FINRA Series 7 — All Questions

A common stockholder in a corporation is generally entitled to which of the following rights?

• a.The right to vote on major corporate matters such as the election of the board of directors✓
• b.A fixed dividend paid before any distribution to bondholders
• c.A guaranteed return of principal at a stated maturity date
• d.A senior claim on assets ahead of secured creditors in a liquidation

Common stock carries voting rights, typically including election of directors and approval of major corporate actions. Dividends on common stock are never guaranteed, and common holders stand last in the liquidation priority, behind creditors and preferred holders.Securities Exchange Act of 1934

An investor owns 100 shares of a company that declares a 2-for-1 forward stock split. After the split, the investor will own:

• a.200 shares at half the pre-split price✓
• b.200 shares at the same pre-split price
• c.100 shares at the same price
• d.50 shares at twice the pre-split price

A 2-for-1 forward split doubles the number of shares while halving the per-share price, leaving total market value unchanged. The investor now holds 200 shares, each worth half of the prior price.

Cumulative preferred stock differs from straight (noncumulative) preferred stock in that cumulative preferred:

• a.Requires that any skipped dividends accumulate and be paid before common dividends resume✓
• b.Can be converted into common stock at the holder's option
• c.Pays a dividend that increases automatically each year
• d.Carries full voting rights equal to common shares

With cumulative preferred, dividends that are missed accumulate as arrears and must be paid in full before the corporation may pay any dividend to common shareholders. Straight preferred loses skipped dividends permanently.

An American Depositary Receipt (ADR) is best described as:

• a.A U.S. government-guaranteed foreign bond
• b.A negotiable receipt representing ownership of shares in a foreign company, trading in U.S. markets✓
• c.A derivative contract on a foreign currency
• d.A mutual fund limited to emerging market equities

An ADR is a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares in a foreign corporation, allowing the shares to trade in U.S. dollars on U.S. markets. ADR holders face currency risk and generally lack full voting rights.

A corporate bond with a 6% coupon is currently trading at a price of 95 (a discount). Compared with the coupon rate, the bond's current yield and yield to maturity will be:

• a.Both equal to the coupon
• b.Both lower than the coupon
• c.Both higher than the coupon✓
• d.Current yield lower, yield to maturity higher

When a bond trades at a discount, its current yield and yield to maturity both exceed the coupon rate, and the yield to maturity is the highest of the three measures because it also captures the gain from par redemption. The ordering at a discount is coupon < current yield < YTM.

An investor buys a $1,000 par bond with a 5% coupon at a price of 80. What is the current yield?

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

Current yield equals annual coupon income divided by market price. The annual coupon is $50, and the market price is $800 (80% of par), so $50 / $800 = 6.25%.

Which statement about the relationship between bond prices and interest rates is correct?

• a.Bond prices are unaffected by changes in interest rates
• b.Bond prices and interest rates move in the same direction
• c.Only long-term bonds are affected by rate changes; short-term bonds are not
• d.When market interest rates rise, existing bond prices fall✓

Bond prices and market interest rates move inversely. When prevailing rates rise, the fixed coupons of existing bonds become less attractive, so their prices fall; when rates fall, existing bond prices rise. Longer maturities are more sensitive, but all fixed-rate bonds are affected.

Interest paid on general obligation municipal bonds to a resident investor is generally:

• a.Fully taxable at the federal, state, and local levels
• b.Taxed as a long-term capital gain
• c.Exempt from federal income tax and often exempt from state tax for in-state residents✓
• d.Subject only to federal tax but exempt from all state tax nationwide

Interest on municipal bonds is generally exempt from federal income tax, and is typically also exempt from state and local tax for residents of the issuing state (the 'triple tax-exempt' feature for in-state holders). This tax treatment is why municipal yields are compared on a taxable-equivalent basis.

An investor in the 32% federal tax bracket is comparing a 4% municipal bond with a taxable corporate bond. What taxable-equivalent yield must the corporate bond offer to match the municipal?

• a.4.00%
• b.2.72%
• c.5.28%
• d.5.88%✓

Taxable-equivalent yield equals the municipal yield divided by (1 minus the tax rate): 4% / (1 - 0.32) = 4% / 0.68 = 5.88%. A taxable bond must yield about 5.88% to give the same after-tax return as the 4% municipal.

A general obligation (GO) municipal bond is backed primarily by:

• a.Insurance from the FDIC
• b.An explicit full-faith-and-credit guarantee provided by the federal government
• c.The full faith, credit, and taxing power of the issuing municipality✓
• d.The net revenue generated by a specific project such as a toll road or toll bridge

A GO bond is secured by the issuer's full faith and credit, including its ability to levy taxes to service the debt. This contrasts with a revenue bond, which is backed only by revenues from a specific facility or project.

A revenue bond issued to finance a municipal water and sewer system is repaid from:

• a.Ad valorem property taxes levied on all real estate within the municipality
• b.Federal grants only
• c.User charges and fees collected from the facility's operations✓
• d.General sales tax revenue collected on retail transactions across the state

Revenue bonds are serviced from the income generated by the specific facility or enterprise they finance, such as user fees from a water and sewer system. Because they lack the issuer's general taxing power backing, analysts examine the project's projected revenues and any debt service coverage requirements.

U.S. Treasury bills are best characterized as:

• a.Securities that pay semiannual interest and mature in 30 years
• b.Short-term securities issued at a discount and maturing at par, with no periodic coupon✓
• c.Long-term coupon-bearing bonds
• d.Bonds backed by specific federal project revenues

Treasury bills are short-term obligations (one year or less) issued at a discount to face value and redeemed at par at maturity; the investor's return is the difference between purchase price and par. They pay no periodic coupon, unlike Treasury notes and bonds.

Interest income from U.S. Treasury securities is:

• a.Completely exempt from federal income tax but fully taxable at the state and local level
• b.Taxable only in the event that the securities are sold before their stated maturity date
• c.Taxable at the federal level but exempt from state and local income tax✓
• d.Fully exempt from all income taxes

Interest on U.S. Treasury securities is subject to federal income tax but is exempt from state and local income taxes. This is the reverse of municipal bonds, whose interest is generally federal-tax-exempt.

A convertible bond gives the holder the right to:

• a.Exchange the bond for a fixed number of common shares of the issuer✓
• b.Demand early repayment of the full principal at any time at par value on request
• c.Receive a variable coupon rate that is directly tied to a broad common stock index
• d.Vote in the issuer's shareholder meetings

A convertible bond can be exchanged, at the holder's option, for a predetermined number of the issuer's common shares based on the conversion ratio. This gives upside participation in the stock while providing bond income, though convertibles typically carry lower coupons in exchange for that feature.

A convertible bond has a par value of $1,000 and a conversion price of $40. How many shares of common stock will the holder receive upon conversion?

• a.25 shares✓
• b.40 shares
• c.4 shares
• d.250 shares

The conversion ratio equals par value divided by the conversion price: $1,000 / $40 = 25 shares. Each bond can be exchanged for 25 shares of the issuer's common stock.

Using a conversion ratio of 25 shares per bond, at what common stock price is a convertible bond trading at parity with a bond market price of $1,050?

• a.$25.00
• b.$42.00✓
• c.$40.00
• d.$26.25

Parity price of the stock equals the bond's market price divided by the conversion ratio: $1,050 / 25 = $42.00. If the stock trades above $42, converting and selling shares would be worth more than the bond's current market price.

A call feature on a corporate bond primarily benefits:

• a.The underwriter, who earns extra commission
• b.The issuer, who can redeem the bonds early, typically when interest rates fall✓
• c.The bondholder, who is thereby guaranteed a permanently higher yield to maturity for life
• d.The rating agency

A call provision lets the issuer redeem bonds before maturity, usually at a small premium. Issuers exercise calls when rates have fallen so they can refinance at lower cost, which exposes bondholders to reinvestment risk. To compensate, callable bonds generally offer higher yields.

Under the Investment Company Act of 1940, an open-end investment company (mutual fund):

• a.Issues a fixed number of shares that trade on an exchange at supply-and-demand-driven prices
• b.Is prohibited from charging any fees
• c.Continuously offers new shares and redeems outstanding shares at net asset value✓
• d.Cannot invest in equity securities

An open-end fund continuously issues new redeemable shares and redeems existing shares at net asset value (NAV), calculated at least daily. This contrasts with a closed-end fund, which issues a fixed number of shares that then trade in the secondary market at prices set by supply and demand.Investment Company Act of 1940

The public offering price (POP) of a mutual fund share with a front-end sales load is calculated as:

• a.Net asset value minus the sales charge
• b.A fixed price set by FINRA
• c.Net asset value plus the sales charge✓
• d.The market price set by exchange trading

For a front-end load fund, the public offering price equals the net asset value per share plus the sales charge. Investors buy at the POP and, absent a load, redeem at NAV. Closed-end funds, by contrast, trade at market prices that may be above or below NAV.Investment Company Act of 1940

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

• a.$20.00
• b.$19.05
• c.$20.05✓
• d.$18.10

When the sales charge is a percentage of the POP, POP = NAV / (1 - sales charge rate) = $19.05 / (1 - 0.05) = $19.05 / 0.95 = $20.05. The sales charge is $1.00, which is 5% of the $20.05 offering price.Investment Company Act of 1940

A breakpoint in a front-end load mutual fund refers to:

• a.The maximum possible loss the fund could ever experience in a market downturn
• b.A reduced sales charge available for larger investment amounts✓
• c.The date the fund pays its annual dividend
• d.A point at which the fund permanently stops accepting any new investors at all

Breakpoints are investment thresholds at which the sales charge percentage decreases; larger purchases qualify for lower loads. A letter of intent or rights of accumulation may let an investor reach a breakpoint over time. Recommending purchases just below a breakpoint to earn a higher commission is a prohibited practice.

An exchange-traded fund (ETF) differs from a traditional open-end mutual fund primarily because an ETF:

• a.Can only be bought once per day at the closing NAV
• b.Is guaranteed against loss by the sponsor
• c.Cannot hold a diversified portfolio
• d.Trades intraday on an exchange at market-determined prices✓

ETF shares trade throughout the day on an exchange like a stock, so investors transact at intraday market prices that may differ slightly from NAV, and can use limit or stop orders. Traditional mutual fund shares are priced once daily at NAV after the market close (forward pricing).

A unit investment trust (UIT) is characterized by:

• a.An actively managed investment portfolio overseen by a formal board of directors
• b.A firm guarantee of the full return of principal at the trust's stated maturity date
• c.A fixed, generally unmanaged portfolio held until a set termination date✓
• d.A perpetual life with continuous trading by managers

A UIT holds a fixed portfolio of securities that is not actively traded and has a predetermined termination date. It has no board of directors or investment adviser making ongoing decisions, distinguishing it from managed open-end and closed-end companies under the Investment Company Act of 1940.Investment Company Act of 1940

A variable annuity's separate account value during the accumulation phase depends on:

• a.The investment performance of the subaccounts selected by the contract owner✓
• b.The consumer price index only
• c.The prime interest rate
• d.A fixed minimum rate of return that is fully guaranteed for life by the issuing insurer

In a variable annuity, premiums are allocated to separate account subaccounts (similar to mutual funds), and the account value fluctuates with the investment performance of those subaccounts. The investor bears the investment risk, unlike a fixed annuity where the insurer guarantees a set rate.

A fixed annuity exposes the contract holder primarily to which risk?

• a.Market risk arising from equity subaccounts whose value tracks the stock market's performance
• b.Currency exchange risk
• c.Liquidity risk equivalent to owning common stock
• d.Purchasing power (inflation) risk, because payments are fixed in dollar terms✓

A fixed annuity guarantees a set payment, so its main drawback is purchasing power risk: over time inflation erodes the real value of level payments. Variable annuities aim to counter inflation risk by investing in securities, but they introduce market risk instead.

A real estate investment trust (REIT) that qualifies for favorable tax treatment must generally:

• a.Be organized as a limited partnership
• b.Guarantee a fixed dividend to investors
• c.Invest only in residential mortgages
• d.Distribute at least 90% of its taxable income to shareholders✓

To qualify as a REIT and avoid corporate-level taxation on distributed income, the trust must distribute at least 90% of its taxable income to shareholders and meet asset and income tests concentrated in real estate. REIT dividends are then generally taxed to shareholders, and REITs are not flow-through vehicles for passing losses.

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

• a.It is taxed as a corporation at the entity level
• b.Units are highly liquid and trade actively on exchanges
• c.Investors have no liability beyond guarantees they sign
• d.Income, gains, losses, and deductions flow through directly to the individual investors✓

A DPP is a flow-through (pass-through) entity: tax items pass directly to the limited partners' individual returns rather than being taxed at the entity level. Limited partners have limited liability but DPP interests are generally illiquid, and losses are typically passive.

An investor buys 1 XYZ call option with a strike price of 50 for a premium of 3. What is the maximum loss on this long call position?

• a.$4,700
• b.Unlimited
• c.$300✓
• d.$5,000

The buyer of a call can lose no more than the premium paid. Here the premium is 3 points times the 100-share multiplier, or $300. If the stock stays at or below 50, the option expires worthless and the $300 premium is the entire loss.

An investor buys 1 XYZ call with a 50 strike for a premium of 3. What is the breakeven point at expiration?

• a.$50
• b.$56
• c.$53✓
• d.$47

For a long call, breakeven equals the strike price plus the premium paid: 50 + 3 = $53. The stock must rise above $53 for the position to be profitable, because the buyer must recover the premium before earning a net gain.

An investor writes (sells) 1 uncovered XYZ call with a 50 strike for a premium of 3. The maximum potential loss is:

• a.Limited to $4,700
• b.Limited to $300
• c.Unlimited✓
• d.Limited to $5,000

An uncovered (naked) call writer faces theoretically unlimited loss because there is no ceiling on how high the underlying stock can rise, and the writer must deliver shares at the strike no matter the market price. The premium received only partially offsets this exposure.

An investor buys 1 XYZ put with a 40 strike for a premium of 2. What is the maximum gain on this long put?

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

A long put profits as the stock falls, but the stock can fall no lower than zero. Maximum gain equals the strike minus the premium, times 100: (40 - 2) x 100 = $3,800, achieved if the stock goes to zero and the holder buys at market and exercises the put to sell at 40.

An investor buys 1 XYZ put with a 40 strike for a premium of 2. What is the breakeven point at expiration?

• a.$42
• b.$40
• c.$44
• d.$38✓

For a long put, breakeven equals the strike price minus the premium paid: 40 - 2 = $38. The stock must fall below $38 for the put buyer to earn a net profit after recovering the premium.

An investor who is bullish on a stock but wants to limit the cost of the position could establish a:

• a.Debit call spread (buy a lower-strike call, sell a higher-strike call)✓
• b.Long straddle
• c.A bearish credit call spread that is established for a net premium credit received
• d.An uncovered short put position that is established with no other offsetting trade

A debit call spread (bull call spread) involves buying a call and selling a higher-strike call, producing a net debit. It profits from a moderate rise in the underlying while capping both cost and maximum gain, making it a lower-cost bullish strategy than buying a call outright.

An investor buys 1 XYZ 50 call for 5 and sells 1 XYZ 60 call for 2. What is the maximum gain on this spread?

• a.$700✓
• b.$300
• c.Unlimited
• d.$1,000

This is a debit call spread with a net debit of 3 points ($5 paid minus $2 received). Maximum gain equals the difference in strikes minus the net debit: (60 - 50) - 3 = 7 points, or $700, realized if the stock is at or above 60 at expiration.

Using the same spread (buy 1 XYZ 50 call for 5, sell 1 XYZ 60 call for 2), what is the maximum loss?

• a.$1,000
• b.$300✓
• c.Unlimited
• d.$700

The maximum loss on a debit spread is the net premium paid. Here the net debit is 3 points (5 - 2), or $300, which is lost if both calls expire worthless with the stock at or below 50.

A long straddle consists of:

• a.Buying a call and buying a put with the same strike and expiration✓
• b.Buying a call option and selling a put option with the same identical strike price
• c.Selling both a call and a put that share the same strike and expiration month
• d.Buying two calls at different strikes

A long straddle is the purchase of both a call and a put on the same underlying with identical strike and expiration. The buyer profits from a large price move in either direction and is said to be buying volatility; the maximum loss is the total premium paid.

An investor buys 1 XYZ 50 call for 4 and 1 XYZ 50 put for 3 (a long straddle). What are the two breakeven points?

• a.$57 and $43✓
• b.$54 and $46
• c.$50 and $50
• d.$61 and $39

For a long straddle, the total premium is 7 points (4 + 3). The upside breakeven is the strike plus total premium (50 + 7 = 57) and the downside breakeven is the strike minus total premium (50 - 7 = 43). The stock must move outside 43 to 57 for a net profit.

An investor owns 100 shares of XYZ and sells 1 XYZ call against the position. This strategy is known as:

• a.A covered call✓
• b.A protective put
• c.A long straddle
• d.A naked call

Selling a call against stock already owned is a covered call. It generates premium income and provides limited downside cushion, but it caps the upside because the shares may be called away if the stock rises above the strike. Because the writer owns the underlying shares, the call is 'covered' rather than naked.

An investor who owns 100 shares of a stock and is worried about a near-term decline could best protect the position by:

• a.Selling a covered call
• b.Buying a protective put✓
• c.Writing a naked put
• d.Selling the stock short

Buying a put while holding the stock (a protective put) creates a floor: no matter how far the stock falls, the holder can sell at the put's strike. The cost is the premium paid, which acts like insurance and reduces the position's net return if the stock rises.

An investor buys 100 shares of XYZ at $48 and buys 1 XYZ 45 put for 2 (a protective put). What is the maximum loss?

• a.$500✓
• b.$300
• c.$4,800
• d.$200

With a protective put, the maximum loss is the stock purchase price minus the put strike, plus the premium paid, times 100: (48 - 45 + 2) x 100 = $500. Below the 45 strike, the put lets the investor sell at 45, capping the loss.

The Options Clearing Corporation (OCC) functions as:

• a.A rating agency for options
• b.A broker-dealer that recommends option strategies
• c.A federal agency that taxes option gains
• d.The issuer and guarantor of listed options contracts✓

The OCC issues all listed options and acts as the central counterparty, guaranteeing performance so that buyers and sellers do not rely on each other's creditworthiness. It also standardizes contract terms and processes assignments, which supports a liquid secondary options market.

Systematic risk refers to:

• a.The risk that is unique to one single company or industry and can be reduced or diversified away entirely
• b.The specific risk that an individual corporate or municipal bond issuer will default on its obligations
• c.Market-wide risk that affects nearly all securities and cannot be eliminated through diversification✓
• d.The risk of buying at the wrong time of day

Systematic (market) risk affects the entire market or broad asset classes and cannot be diversified away; examples include recessions and broad interest rate moves. Unsystematic (nonsystematic) risk is company- or industry-specific and can be reduced through diversification.

Reinvestment risk is most significant for an investor who:

• a.Holds all of their money in a non-interest-bearing bank checking account for many years
• b.Owns high-coupon bonds and must reinvest the periodic interest at prevailing rates✓
• c.Owns common stock paying no dividend
• d.Holds a zero-coupon bond to maturity

Reinvestment risk is the danger that periodic cash flows (coupons or called principal) must be reinvested at lower prevailing rates, reducing overall return. High-coupon and callable bonds are especially exposed. A zero-coupon bond held to maturity has no interim cash flows to reinvest, so it avoids this risk.

Credit (default) risk on a corporate bond is best assessed by reviewing:

• a.The issuer's common stock dividend payout ratio and its recent dividend history
• b.The total number of common shares the issuing corporation has outstanding
• c.The frequency with which the corporate bond pays out its stated periodic coupon
• d.The issuer's credit rating from a recognized rating agency✓

Credit risk is the possibility that the issuer fails to pay interest or principal. Independent credit ratings from recognized agencies summarize an issuer's ability to meet obligations, with investment-grade ratings indicating lower default risk than high-yield (speculative) ratings, which pay higher coupons to compensate.

A zero-coupon bond is purchased at a deep discount and:

• a.Pays a fixed amount of cash interest every month until its stated maturity date
• b.Can only ever be issued by state and local government municipalities themselves
• c.Pays no periodic interest, returning full par value at maturity✓
• d.Pays a floating coupon tied to inflation

A zero-coupon bond makes no periodic interest payments; the investor's return is the difference between the discounted purchase price and the par value received at maturity. Because there are no coupons to reinvest, zeros avoid reinvestment risk but are highly sensitive to interest rate changes.

Which of the following bonds is generally most sensitive to a given change in interest rates?

• a.A high-coupon bond maturing in two years
• b.A long-term, low-coupon (or zero-coupon) bond✓
• c.A short-term, high-coupon bond
• d.A bond maturing in 90 days

Interest rate (price) sensitivity, measured by duration, increases with longer maturities and lower coupons. A long-term, low- or zero-coupon bond has the highest duration and therefore experiences the largest price swing for a given change in market rates.

A mortgage-backed pass-through security, such as a GNMA (Ginnie Mae) certificate, passes through to investors:

• a.A guaranteed fixed redemption price regardless of prevailing market interest conditions
• b.Only monthly interest payments, with the principal returned solely at final maturity
• c.Corporate dividends
• d.Monthly payments of both principal and interest from a pool of mortgages✓

A mortgage pass-through security distributes to investors the monthly principal and interest payments collected from an underlying pool of mortgages. Because homeowners can prepay their loans, these securities carry prepayment risk, which accelerates return of principal when rates fall.

Prepayment risk in mortgage-backed securities means that:

• a.Interest rates will always rise
• b.The bonds cannot be sold before maturity
• c.The issuer will default on interest payments
• d.When interest rates fall, homeowners refinance and return principal sooner than expected✓

Prepayment risk arises because falling interest rates prompt homeowners to refinance, returning principal to investors earlier than expected. Investors then must reinvest that principal at the new, lower rates, which is a form of reinvestment risk specific to mortgage-backed securities.

A warrant differs from a right in that a warrant:

• a.Is always issued and priced at a level below the current market price of the underlying stock
• b.Must be exercised within days of issuance
• c.Pays a fixed dividend
• d.Typically has a long life and an exercise price initially above the market price✓

A warrant is a long-term instrument (often years) to buy stock at a set price, usually issued with an exercise price above the current market. A right (preemptive right) is short-term, usually lasting weeks, and lets existing shareholders buy new shares at a subscription price below market.

A money market instrument such as commercial paper is best described as:

• a.A municipal general obligation bond
• b.A short-term, unsecured corporate debt obligation, typically maturing in 270 days or less✓
• c.A federally insured deposit
• d.A long-term equity security

Commercial paper is short-term, unsecured corporate debt issued at a discount, usually with maturities of 270 days or less so that it is exempt from full registration under the Securities Act of 1933. It is a money market instrument used by corporations for short-term financing.