FINRA SIE — Securities Industry Essentials — All Questions

Under FINRA Rule 3110, which of the following must a member firm's supervisory system include?

• a.FINRA's advance approval of each written supervisory procedure
• b.Principal review of only those transactions above a set dollar amount
• c.Annual inspection of every branch, including non-supervisory ones
• d.Written procedures reasonably designed to achieve compliance✓

Rule 3110 requires a supervisory system reasonably designed to achieve compliance, backed by written procedures. Those procedures must provide for principal review of all transactions, not just large ones; FINRA does not pre-approve a firm's procedures; and annual inspection is required only for offices of supervisory jurisdiction and supervisory branches, while non-supervisory branches must be inspected at least every three years.FINRA Rule 3110

The SEC is directly responsible for all of the following EXCEPT:

• a.Overseeing FINRA and the national securities exchanges
• b.Bringing civil actions against securities-law violators
• c.Reviewing registration statements filed by issuers
• d.Licensing registered representatives and administering their exams✓

The SEC reviews registration statements, brings civil enforcement actions, and oversees the self-regulatory organizations, including FINRA and the exchanges. Registering and licensing representatives and administering the qualification exams, including the SIE, is done by FINRA, not by the SEC.Securities Exchange Act of 1934

Which kind of company does the Investment Company Act of 1940 generally require to register with the SEC as an investment company?

• a.A company mainly engaged in investing and trading in securities✓
• b.An investment adviser that manages individual client portfolios for fees
• c.An operating company that sells stock in an IPO to fund its factories
• d.A broker-dealer that carries and clears customer accounts

The 1940 Act applies to issuers that are, or hold themselves out as, primarily engaged in investing, reinvesting, or trading in securities, such as mutual funds and closed-end funds. A broker-dealer is regulated under the Securities Exchange Act of 1934, an investment adviser under the Investment Advisers Act of 1940, and an operating company registers its offering under the Securities Act of 1933 rather than registering as an investment company.Investment Company Act of 1940 Section 3(a)(1)

An employee acquired fully paid, restricted shares of a company that files periodic reports under the Exchange Act. She is not an affiliate of the issuer. Assuming every other Rule 144 condition is met, what is the minimum holding period before she may resell the shares?

• a.Six months✓
• b.Twelve months
• c.Twenty-four months
• d.Three months

Under Rule 144(d), restricted securities of a reporting issuer must be held at least six months. Twelve months (one year) is the period when the issuer is not a reporting company. Three months and twenty-four months are not Rule 144 holding periods; the three-month period matters only for the volume and Form 144 measurements.17 CFR 230.144(d)

A director of an exchange-listed company, who is an affiliate, plans to sell under Rule 144. The company has 8,000,000 shares of the class outstanding, and average weekly trading volume over the preceding four calendar weeks was 62,000 shares. What is the most she may sell in any three-month period under the volume limit?

• a.142,000 shares
• b.80,000 shares✓
• c.62,000 shares
• d.8,000 shares

Rule 144(e) caps an affiliate at the greater of 1% of the class outstanding or the four-week average weekly volume. Here 1% is 80,000 and the weekly average is 62,000, so 80,000 governs. 62,000 uses only the lesser measure, 142,000 wrongly adds the two figures, and 8,000 is 0.1% of the class.17 CFR 230.144(e)

In a popular IPO, the syndicate sold 5,500,000 shares against a base deal of 5,000,000 shares, leaving it short 500,000 shares. The stock now trades well above the offering price. How does the syndicate most economically cover that short position?

• a.It exercises the greenshoe, buying 500,000 shares from the issuer at the offering price✓
• b.It asks the issuer to repurchase the 500,000 shares sold in excess of the base deal
• c.It buys 500,000 shares in the open market at the higher prevailing trading price
• d.It cancels the confirmations on the last 500,000 shares sold to investors

The over-allotment (greenshoe) option lets the syndicate buy extra shares from the issuer at the offering price, which beats paying the higher market price when the stock trades up. Buying in the open market is the better route only when the price has fallen below the offering price. Confirmed orders cannot simply be cancelled, and selling shares back to the issuer would not cover a short position.FINRA Rule 5110

A corporation offers its existing shareholders the right to buy new shares at a discount. Before the offering, a broker-dealer agrees to purchase, at the subscription price, any shares the shareholders do not take. What is this arrangement called?

• a.All-or-none underwriting
• b.Standby underwriting✓
• c.Best-efforts underwriting
• d.Firm-commitment underwriting

A standby underwriter backs a rights offering by agreeing to buy whatever shares shareholders leave unsubscribed. Best-efforts means the underwriter only tries to sell and assumes no purchase obligation. All-or-none cancels the whole offering unless every share is sold. Firm-commitment means buying the entire issue up front to resell it to the public.

A private company wants to advertise its securities offering on a public website and in social-media posts. Which statement about general solicitation under Regulation D is correct?

• a.Rule 506(b) permits it if every purchaser is accredited and signs a written self-certification
• b.Rule 506(c) permits it if every purchaser is accredited and the issuer verifies that status✓
• c.Rule 506(c) permits it if up to 35 purchasers are non-accredited but each is financially sophisticated
• d.Rule 506(b) permits it if no more than 35 purchasers are non-accredited and each is sophisticated

Rule 506(c) allows general solicitation, but all purchasers must be accredited and the issuer must take reasonable steps to verify it. Rule 506(b) prohibits general solicitation even if every buyer is accredited, so neither 506(b) option works. The allowance for up to 35 sophisticated non-accredited purchasers belongs to 506(b), not 506(c).17 CFR 230.506(c)

Rule 144A permits resales of restricted securities to qualified institutional buyers (QIBs). Apart from registered broker-dealers, an institution generally qualifies as a QIB if it owns and invests on a discretionary basis at least how much in securities of unaffiliated issuers?

• a.$50 million
• b.$10 million in securities of unaffiliated issuers
• c.$100 million✓
• d.$5 million in total assets

Under Rule 144A(a)(1), most institutions need at least $100 million in securities of unaffiliated issuers owned and invested on a discretionary basis. Registered dealers have a lower $10 million test. A $5 million total-assets figure is an entity threshold for accredited-investor status under Regulation D, and $50 million is not a Rule 144A figure.17 CFR 230.144A(a)(1)

The economy is experiencing slowing output, rising unemployment and rising consumer prices at the same time. Which term describes this condition?

• a.Deflation
• b.Stagflation✓
• c.Disinflation
• d.Hyperinflation

Stagflation combines stagnant growth and high unemployment with rising prices. Disinflation is a slowdown in the rate of inflation while prices still rise, with no link to rising unemployment. Hyperinflation is extremely rapid, out-of-control price growth, which does not describe stagnating output and unemployment. Deflation is a general fall in prices.

The Treasury 2-year yield is 4.10% and the 10-year yield is 4.15%. Which term best describes the yield curve between those two maturities?

• a.Humped
• b.Slightly inverted
• c.Nearly flat✓
• d.Steeply upward-sloping

When yields across maturities are almost the same, as here with a gap of 0.05 percentage point, the curve is flat. An inverted curve, even a slightly inverted one, needs short-term yields above long-term yields, but here the 10-year yield is higher. A steep normal curve has long-term yields well above short-term yields. A humped curve needs intermediate maturities to yield more than both ends.

Which Federal Reserve action is an example of quantitative easing?

• a.Selling Treasury securities from its portfolio to remove reserves and push short-term rates up
• b.Raising the target range for the federal funds rate by 0.25 percentage point to slow inflation
• c.Cutting the discount rate so that banks can borrow from the Fed's discount window more cheaply
• d.Buying large amounts of longer-term Treasury and agency mortgage-backed securities to lower long-term yields✓

Quantitative easing is large-scale purchasing of longer-term securities, such as Treasuries and agency mortgage-backed securities, to lower longer-term yields. Selling securities drains reserves and tightens policy. A lower discount rate and a higher federal funds target are changes in policy rates, not asset-purchase programs.

A stock closed at $48 per share. The company pays a regular quarterly cash dividend of $0.60 per share. What is the stock's current dividend yield?

• a.2.50%
• b.1.25%
• c.5.0%✓
• d.20.0%

Dividend yield is the annual dividend divided by the current price: 4 x $0.60 = $2.40, and $2.40 / $48 = 5.0%. 1.25% divides only one quarterly payment by the price, 2.5% annualizes as if the dividend were paid twice a year, and 20% inverts the ratio.

A stock closed Monday at $50.00. On Tuesday morning it trades down to $44.50, an 11% decline from Monday's close, which triggers the SEC's alternative uptick rule (Rule 201). Which restriction applies?

• a.Short sales may not execute at or below the national best bid for the rest of Tuesday and all of Wednesday✓
• b.Short sales may execute only on a plus tick or zero-plus tick, for the rest of Tuesday only
• c.Short sales are barred outright for the rest of Tuesday and Wednesday unless the order is marked short exempt
• d.Trading halts for 15 minutes, then short sales resume under normal rules for the rest of Tuesday

Rule 201 applies once a stock falls 10% or more from the prior close: for that day and the next, short sales may not be executed or displayed at or below the national best bid. It restricts price, not all short selling. The plus-tick test is the old rule that was repealed, and a 15-minute pause belongs to a different mechanism (volatility halts), not to Rule 201.17 CFR 242.201

In a cash account with no other funds, a customer buys $5,000 of stock on Monday. On Tuesday, before sending any payment, she sells the same shares and uses the proceeds to cover the purchase. What is the consequence under Regulation T?

• a.For 90 calendar days she must pay in full before the firm will accept any buy order✓
• b.The firm must liquidate the account and bar her from opening another cash account for 90 calendar days
• c.For 30 calendar days she must pay in full before the firm will accept any buy order
• d.None, because the sale proceeds covered the purchase and the position was flat at the close

Selling securities that were never paid for is free-riding, and Regulation T 220.8(c) withdraws the privilege of delaying payment for 90 calendar days, so she must pay up front. The period is 90 days, not 30. Having the proceeds cover the cost does not excuse the violation, and the rule does not require liquidating or barring the account.12 CFR 220.8(c)

A customer buys $30,000 of marginable stock in a margin account, putting up the Regulation T initial requirement of 50% and borrowing the rest. The debit balance stays at $15,000 and no interest accrues. At what market value is the account exactly at the 25% maintenance requirement?

• a.$18,750
• b.$15,000
• c.$22,500
• d.$20,000✓

Equity equals market value minus the $15,000 debit. Setting equity at 25% of market value gives MV - 15,000 = 0.25 x MV, so 0.75 x MV = 15,000 and MV = $20,000. $22,500 is 75% of the original $30,000, $18,750 adds 25% to the debit, and $15,000 is the value at which equity falls to zero.FINRA Rule 4210(c)(1)

A stock goes ex-dividend today with a $0.50 cash dividend. A customer has two open GTC orders: a buy limit at $40.00 and a sell limit at $48.00. Absent a 'Do Not Reduce' instruction, what are the orders after the standard ex-date adjustment?

• a.Buy limit at $39.50; sell limit at $47.50
• b.Buy limit at $40.00; sell limit at $48.00
• c.Buy limit at $39.50; sell limit at $48.00✓
• d.Buy limit at $40.00; sell limit at $47.50

Under FINRA Rule 5330, open buy orders and open sell stop orders are reduced by the cash dividend on the ex-date, so the $40.00 buy limit becomes $39.50. Open sell limit orders are not reduced and stay at $48.00. The other pairings either reduce the sell limit, skip the buy limit, or adjust nothing.FINRA Rule 5330

An investor holds a stock that closed at $52 and has an open sell stop order at $50. Overnight bad news makes the stock open at $46. What generally happens to the order?

• a.It fills at $50, because a stop order guarantees execution at the stop price once triggered
• b.It becomes a limit order at $50 and stays unfilled because $46 is below that price
• c.It stays unfilled because the stock opened below $50 and never traded at exactly $50
• d.It becomes a market order once the stock trades at or below $50 and fills at or near $46✓

A sell stop is triggered when the stock trades at or below the stop price, and it then becomes a market order, so the fill is at or near the $46 opening price. Stop orders do not guarantee the stop price. Becoming a limit order at $50 describes a stop-limit order, not a plain stop. A gap through $50 still triggers the stop.

Under FINRA Rule 2341, an open-end fund may be described as 'no-load' only if it charges:

• a.No front-end or deferred load, but a 0.75% annual 12b-1 fee
• b.No front-end load, no deferred charge, and a 0.25% annual 12b-1 fee✓
• c.No front-end or deferred load, but a 0.50% annual 12b-1 fee
• d.No front-end load, a 1% first-year deferred charge, no 12b-1 fee

Rule 2341 bars calling a fund no-load if it has a front-end or deferred sales charge or if its charges against net assets exceed 0.25% of average net assets per year, so a 0.25% 12b-1 fee still qualifies. A 0.50% or 0.75% 12b-1 fee is over that line (0.75% is the cap on asset-based sales charges, not the no-load line), and a deferred charge disqualifies a fund even when it has no 12b-1 fee.FINRA Rule 2341

A mutual fund's net asset value is $24.70 per share, and its prospectus sales charge is 5.75% of the offering price. What is the public offering price per share, rounded to the nearest cent?

• a.$26.12, found by multiplying NAV by 1.0575
• b.$23.36, found by dividing NAV by 1.0575
• c.$26.21, found by dividing NAV by 0.9425✓
• d.$23.28, found by multiplying NAV by 0.9425

The sales charge is a percentage of the offering price, so POP = NAV / (1 - 0.0575) = $24.70 / 0.9425 = $26.21. Multiplying NAV by 1.0575 gives $26.12, which wrongly treats the load as a percentage of NAV. Dividing NAV by 1.0575 gives $23.36 and multiplying NAV by 0.9425 gives $23.28; both land below NAV, but a buyer who pays a load pays more than NAV.

An investor owns shares of a growth fund that have risen in value. Using the fund family's exchange privilege, she moves them into a bond fund of the same family and receives no cash. For federal income tax purposes, the exchange is treated:

• a.As a nontaxable event, because she received no cash and stayed in one fund family
• b.As taxable only if she exchanged the shares within 30 days of buying them
• c.As a tax-deferred exchange, like an annuity contract exchange under Section 1035
• d.As a sale of the growth fund shares, with any gain or loss reported that year✓

IRS Publication 550 treats any exchange of one fund's shares for another's as a sale, even inside one fund family, so the gain or loss is reported for the year of the exchange. Section 1035 covers exchanges of annuity and insurance contracts, not fund shares. Receiving no cash or staying in one family does not make the exchange tax-free, and there is no 30-day condition (the 30-day window belongs to the wash-sale rule for losses).IRS Publication 550

On Monday a client invests $20,000 in a mutual fund at a NAV of $25.00 per share. On Wednesday the fund pays a $1.00 per share capital gain distribution, its NAV drops to $24.00, and the client takes the payment in cash. For federal income tax purposes, the $1.00 per share distribution:

• a.Is not taxable, because the NAV fell by the same amount and her total value is unchanged
• b.Is taxable as a short-term gain, because she held the shares for only two days
• c.Is taxable to her as a long-term capital gain, even though she held the shares only two days✓
• d.Is a return of capital that lowers her cost basis and is untaxed until she sells

A capital gain distribution is always treated as a long-term capital gain by the shareholder, whatever the holding period, and a cash distribution is taxable when received. The matching drop in NAV does not remove the tax, and a capital gain distribution is not a nontaxable return of capital; buying just before a distribution simply brings forward a tax bill on gains the client did not earn.IRC Section 852(b)(3)

A mutual fund's operating expenses for the year were $3.6 million. Its net assets were $500 million at the start of the year, $400 million at the end, and averaged $450 million over the year. What is the fund's expense ratio?

• a.0.08%, with the decimal point misplaced
• b.0.80%, dividing by average net assets✓
• c.0.72%, dividing by starting net assets
• d.0.90%, dividing by year-end net assets

The expense ratio is annual operating expenses divided by average net assets: $3.6 million / $450 million = 0.80%. Using year-end assets gives 0.90%, using starting assets gives 0.72%, and 0.08% results from misplacing the decimal point.

In the ETF structure, which party can deal directly with the fund by creating or redeeming large blocks of shares called creation units?

• a.Only the exchange's specialist, who issues new shares whenever demand exceeds supply
• b.The fund's custodian bank, which buys and sells units for cash at a price posted by the sponsor
• c.An authorized participant, usually a large broker-dealer, using a basket of securities✓
• d.Any retail investor, by placing a market order that the ETF fills at the end-of-day NAV

Authorized participants, usually large broker-dealers, create and redeem creation units with the fund, typically in exchange for a basket of securities, and their arbitrage helps keep the market price near NAV. Retail investors trade ETF shares in the secondary market at market prices, not at NAV with the fund; an exchange specialist does not issue ETF shares; and a custodian only safeguards fund assets.Investment Company Act Rule 6c-11

A customer wants to hold a 2x daily leveraged index ETF for six months, expecting twice the index's six-month return. What should the representative explain?

• a.Because the fund resets daily, compounding can make its six-month return differ widely from 2x the index✓
• b.The swap counterparties that supply the leverage guarantee the 2x result over any period
• c.The fund's six-month return will equal twice the index return, because the fund targets a 2x multiple
• d.The six-month result will differ from 2x only if the ETF trades at a premium or discount to NAV

Leveraged and inverse ETFs generally reset daily, so their stated objective applies to a single day; over longer periods compounding can produce results that differ significantly from the stated multiple, and FINRA Regulatory Notice 09-31 says such products are typically unsuitable for retail investors who hold them beyond one trading session. The 2x multiple is not delivered over six months, a premium or discount to NAV is not the cause of the gap, and swap counterparties do not guarantee a multi-period outcome.FINRA Regulatory Notice 09-31

A closed-end fund has a NAV of $16.00 per share, and its shares trade on an exchange at $14.40. The shares are trading:

• a.At a 10.0% premium to NAV
• b.At an 11.1% premium to NAV
• c.At a 10.0% discount to NAV✓
• d.At an 11.1% discount to NAV

A market price below NAV is a discount, measured against NAV: ($16.00 - $14.40) / $16.00 = 10.0%. Dividing the $1.60 gap by the $14.40 market price gives 11.1%, which uses the wrong base, and a premium would require a market price above NAV.

An ETN tracks a commodity index. The index is unchanged over a month, yet the ETN's market price falls 12% right after its issuing bank's credit rating is cut. This illustrates that:

• a.ETNs are unsecured debt of the issuer, so holders bear its credit risk and own no underlying assets✓
• b.ETN prices are reset daily against the index, so a flat month still produces losses through compounding
• c.Authorized participants redeemed creation units, which forced the ETN to sell commodities at a discount
• d.ETNs hold the issuer's bonds as collateral, so a downgrade lowers the ETN's net asset value directly

An exchange-traded note is an unsecured debt obligation of the issuing bank, so its price depends on the issuer's creditworthiness as well as on the index, and holders own none of the underlying assets. An ETN does not hold collateral bonds or a basket of commodities, the daily-reset compounding problem belongs to leveraged and inverse products rather than explaining a drop with a flat index, and an ETN has no creation-unit redemption by authorized participants forcing asset sales.

Which statement about a non-traded REIT is accurate?

• a.Its shares can be sold any time on an exchange, but at deeper discounts than listed REITs
• b.Part of its distributions may come from offering proceeds or borrowed money✓
• c.It must redeem shares on demand each business day at NAV, as an open-end fund does
• d.It is exempt from SEC registration because its shares do not trade on an exchange

SEC investor guidance warns that non-traded REITs may pay distributions from offering proceeds or borrowings, not only from operating cash flow, which reduces the money available to buy properties. Non-traded REITs are illiquid and any redemption program is limited and can be suspended, so they are not open-end funds redeemable on demand; many are SEC-registered offerings, so no registration exemption applies; and they have no exchange market at all, which is the source of the liquidity problem.

A retiree annuitized a variable annuity with a 4% assumed interest rate (AIR). Over the next year the separate account's net return is 7%. What happens to the monthly payment?

• a.It stays the same, because the payment was fixed at annuitization
• b.It increases, because the separate account's 7% net return beat the 4% AIR✓
• c.It decreases, because a 7% return reduces the retiree's annuity units
• d.It increases only if the insurer's general account also earns above 7%

A variable annuity payment equals a fixed number of annuity units times the current unit value, and the unit value rises when the separate account's net return exceeds the AIR and falls when it is lower. A payment fixed at annuitization describes a fixed annuity, performance does not change the number of annuity units, and the general account backs fixed annuities and plays no role in a variable payout.

A 50-year-old owner of a nonqualified variable annuity bought in 2015 has a contract value of $120,000 and a cost basis of $90,000. He withdraws $20,000 as a lump sum before annuitizing. What is the federal tax result?

• a.The full $20,000 is long-term capital gain, plus a 10% additional tax of $2,000
• b.Nothing is taxed, because the $20,000 is less than his $90,000 cost basis
• c.The full $20,000 is ordinary income, plus a 10% additional tax of $2,000✓
• d.$5,000 is ordinary income, plus a 10% additional tax of $500

A withdrawal from a nonqualified annuity before the annuity starting date is taxed earnings first, so all $20,000 comes out of the $30,000 of gain and is ordinary income, and because he is under 59 1/2 the 10% additional tax applies to that taxable amount ($2,000). The pro rata $5,000 share ignores earnings-first ordering, annuity earnings are taxed as ordinary income rather than capital gain, and basis comes out only after earnings are exhausted.IRC Sections 72(e) and 72(q)

A retiree annuitizes an annuity under a life-with-10-year-period-certain option and dies in the fourth year of payments. What happens?

• a.The insurer pays the named beneficiary for the remaining six years of the guaranteed period✓
• b.Payments stop at death, because the insurer's obligation is limited to the annuitant's life
• c.The beneficiary receives payments for the beneficiary's own lifetime, as under a joint and survivor option
• d.The beneficiary receives ten more years of payments, counted from the date of death

A life annuity with a 10-year period certain pays for the annuitant's life but for at least ten years, so a death in year four leaves six guaranteed years that go to the beneficiary. Stopping at death describes the life-only option, lifetime payments to a survivor describe a joint and survivor option, and the ten years are counted from the start of payments rather than from the date of death.

An investor with a $150,000 salary owns an equipment-leasing limited partnership interest that produced a $30,000 loss this year. She also has $10,000 of passive income from another limited partnership. How much of the loss can she deduct this year?

• a.$10,000, against her other passive income, with the remaining $20,000 carried forward✓
• b.$0 this year, because passive losses stay suspended until the partnership interest is sold
• c.$3,000, against her ordinary income, with the remainder carried forward indefinitely
• d.$30,000, against her salary, because partnership losses pass through to her return

Losses from a limited partnership interest are passive, and passive losses are deductible only against passive income (IRC Section 469), so $10,000 offsets her other partnership income and the excess $20,000 is carried forward. Pass-through reporting does not let passive losses offset salary, the $3,000 figure is the net capital loss limit rather than a passive-loss rule, and suspension until sale applies only to the excess, not to the part that offsets passive income.IRC Section 469

An investor puts $10,000 into a 3-year index-linked note that pays, at maturity, 150% of the index's percentage gain, with a maximum total return of 20% of principal. The index rises 14% over the term, and the issuer pays in full. What is the maturity payment?

• a.$11,400, because the 150% participation rate is not applied
• b.$13,000, because the 150% rate is applied to the 20% cap
• c.$12,000, because the 21% result is limited to the 20% cap✓
• d.$12,100, because the 20% cap is not applied

150% x 14% = 21%, which exceeds the 20% cap, so the return is limited to 20% and the payment is $10,000 x 1.20 = $12,000. $12,100 ignores the cap, $11,400 ignores the 150% participation rate (14% only), and $13,000 wrongly applies the 150% participation rate to the cap itself (30%).

A bond with a $1,000 par value and a 7% coupon is quoted at 87.5. What is its current yield?

• a.7.0%, the $70 interest divided by the $1,000 par value
• b.12.5%, the $125 discount divided by the $1,000 par value
• c.14.3%, the $125 discount divided by the $875 price
• d.8.0%, the $70 interest divided by the $875 price✓

A quote of 87.5 means 87.5% of par, or $875. Current yield is annual interest divided by market price: $70 / $875 = 8.0%. Dividing by par gives the 7.0% nominal yield, which ignores the price paid. The two discount-based figures measure how far below par the bond trades, not the income it produces.

A 15-year, 6% bond is bought at 108 and can be called at 100 in three years. Which of the bond's yields is likely the lowest?

• a.Yield to call, since the $80 premium is amortized over only three years✓
• b.Nominal yield, which stays fixed at the 6% coupon rate regardless of price
• c.Current yield, which divides the $60 coupon by the $1,080 market price
• d.Yield to maturity, which spreads the $80 premium over all fifteen years

If the bond is called at par in three years, the investor loses the full $80 premium over a very short period, which drags yield to call well below the other measures. Yield to maturity spreads the same premium over fifteen years, so it is higher. Current yield (about 5.6%) ignores premium amortization, and the 6% nominal yield is the highest of the four.

A bond fund has a modified duration of 7. If market interest rates rise by one percentage point, the fund's price should change by approximately:

• a.Falls about 7%, roughly $70 on each $1,000 invested✓
• b.Falls about 14%, since coupons are paid semiannually
• c.Falls about 1%, the same size as the rate move
• d.Rises about 7%, roughly $70 gained on each $1,000

Modified duration estimates the percentage price change for a one-percentage-point move in yields, and the price moves in the opposite direction from rates. A duration of 7 therefore implies a decline of about 7%. A gain has the direction backwards, a 1% decline ignores the duration entirely, and doubling the figure for semiannual coupons is not part of the estimate.

A company grants shareholders one right per share owned, and five rights plus $40 are needed to buy one new share. A shareholder owns 300 shares and exercises all of her rights. How many new shares does she buy, and what does she pay?

• a.60 new shares for a total of $12,000
• b.60 new shares for a total of $2,400✓
• c.300 new shares for a total of $12,000
• d.1,500 new shares for a total of $60,000

She receives 300 rights, and each new share takes five of them, so she can buy 300 / 5 = 60 shares at $40 each, or $2,400. Buying 300 shares ignores the five-to-one ratio. Multiplying rights by five reverses the ratio. Paying $40 for every right, rather than for every five, overstates the cost of 60 shares.

A sponsored ADR represents 5 ordinary shares of a foreign company, and each ordinary share is worth $6.00 in U.S. dollar terms in its home market. Ignoring fees, about where should the ADR trade?

• a.Near $11.00, the share value plus the 5-share ratio
• b.Near $1.20, the share value divided by the 5-share ratio
• c.Near $30.00, the value of the 5 underlying shares✓
• d.Near $6.00, the value of a single ordinary share

Each ADR is a claim on five ordinary shares held by a custodian, so its price tracks 5 x $6.00 = $30.00, and arbitrage keeps the two markets aligned. Pricing it at one share's value ignores the ratio. Dividing by five applies the ratio in the wrong direction, and adding the ratio to the share price is not a valuation method.

An investor buys one XYZ 60 put at a premium of $4.00. At what stock price does the investor break even at expiration, ignoring commissions?

• a.$64 per share, the strike price plus the premium
• b.$52 per share, the strike minus twice the premium
• c.$60 per share, equal to the strike price
• d.$56 per share, the strike minus the premium✓

A put buyer profits only when the stock falls far enough below the strike to recover the premium, so breakeven is $60 - $4 = $56. Adding the premium is the call buyer's formula. At the strike itself the put is worth zero and the $4 premium is lost. Subtracting the premium twice counts the cost double.OCC Characteristics and Risks of Standardized Options

An investor buys 100 shares of ABC at $48 and sells one ABC 50 call for a $2 premium. Ignoring commissions, which statement about the position is correct?

• a.Breakeven is $48 and the maximum gain is $200
• b.Breakeven is $50 and the gain is uncapped
• c.Breakeven is $46, and the maximum gain is $400✓
• d.Breakeven is $46 and the maximum gain is $200

The $2 premium lowers the breakeven to $48 - $2 = $46. The most the investor can make is the $2 stock gain up to the strike plus the $2 premium, or $4 per share and $400 in total, because the shares are called away at $50. A breakeven of $48 ignores the premium, a $200 maximum leaves out either the stock gain or the premium, and the upside is capped rather than unlimited.OCC Characteristics and Risks of Standardized Options

XYZ trades at $62. An XYZ 70 put sells for a premium of $10. What is the put's time value?

• a.$2, the premium minus $8 of intrinsic value✓
• b.$18, the premium plus the intrinsic value
• c.$10, the full premium paid for the put
• d.$8, the amount the put is in the money

The put is $8 in the money ($70 - $62), so $8 of the $10 premium is intrinsic value and the remaining $2 is time value. The $8 figure is the intrinsic value itself. The full premium is intrinsic value plus time value, not time value alone, and adding the two components together double counts the intrinsic value.

An investor writes one DEF 40 put and collects a $3 premium. Ignoring commissions, what is the most the writer can lose?

• a.$3,700, reached if DEF falls all the way to zero✓
• b.$4,000, the strike price times 100 shares
• c.$4,300, the strike plus premium times 100
• d.$300, the premium that the writer collected

If DEF falls to zero, the writer must buy 100 shares at $40 for $4,000 and the stock is worthless, but the $300 premium offsets part of that, leaving a maximum loss of $3,700. The premium is the writer's maximum gain, not the maximum loss. Ignoring the premium gives $4,000, and adding the premium instead of subtracting it gives $4,300.OCC Characteristics and Risks of Standardized Options

A TIPS was issued with $1,000 of principal and a 2% fixed coupon. After a year of inflation, its adjusted principal is $1,030. What annual interest does the coupon produce at that point?

• a.$50.60, the interest plus the $30 principal adjustment
• b.$20.00, the coupon applied to the original principal
• c.$20.60, 2% of the adjusted $1,030 principal✓
• d.$30.90, 3% applied to the adjusted principal

A TIPS coupon rate is fixed, but it is applied to the inflation-adjusted principal, so the interest is 2% x $1,030 = $20.60. Using the original $1,000 ignores the adjustment. The $30 adjustment raises principal, it is not interest, and 3% is the inflation rate, not the coupon rate.Treas. Reg. 1.1275-7

An investor holds a TIPS in a taxable account, and the CPI adjustment raises its principal by $30 during the year. How is the $30 increase treated for federal income tax?

• a.It is taxable that year, though the cash arrives only at maturity or sale✓
• b.It is deferred and taxed as a capital gain when the TIPS matures
• c.It is exempt from federal tax, just as it is exempt from state and local tax
• d.It is taxed at the lower qualified-dividend rate because no cash is received

TIPS principal adjustments are treated as taxable interest in the year they occur, creating tax on income the holder has not yet received. They are not deferred until maturity and they are not capital gains. The state and local exemption on Treasury interest does not extend to federal tax, and qualified-dividend rates apply to stock dividends, not to bond income.Treas. Reg. 1.1275-7

A resident of State A buys a State A general obligation municipal bond and, separately, a State B general obligation bond of the same quality. How is the interest on the two bonds generally taxed?

• a.Both are federally exempt, but State A taxes the interest on both of them
• b.Both are exempt from federal and State A tax, since state tax follows the federal exemption
• c.Only the State A bond is federally exempt, because the State B bond is out-of-state
• d.Both are federally exempt, but only the State A bond is generally exempt from State A tax✓

Municipal interest is generally exempt from federal income tax regardless of the issuing state. State exemption usually applies only to bonds issued within the investor's own state, so the State B interest is generally taxable by State A. Exemption does not automatically follow from the federal rule, a state does not tax its own bonds in this situation, and out-of-state status does not affect the federal exemption.IRC Section 103

An investor buys a tax-exempt municipal bond at par and sells it 18 months later at 104 after market rates fall. The $40 per-bond profit is:

• a.taxed at ordinary income rates, because bond profits are treated as interest income
• b.taxed federally as a long-term capital gain, though the coupon stays exempt✓
• c.exempt from federal tax but counted as income under the alternative minimum tax
• d.exempt from federal tax, because the bond itself was issued as a tax-exempt security

The exemption covers the coupon interest, not a profit from selling the bond at a higher price. That profit is a capital gain, and since the bond was held for more than one year it is long-term. Treating the gain as exempt, as ordinary interest, or as an AMT item misreads what the exemption covers.

A company's 5% non-cumulative preferred stock misses its dividend this year, and the company resumes paying dividends the next year. What is the status of the missed payment?

• a.It accrues as a dividend in arrears that must be paid before any common dividend
• b.It is a default that lets preferred holders force liquidation of the company
• c.It is lost, and the company owes only the current dividend ahead of any common dividend✓
• d.It converts into additional preferred shares issued to the holders

Non-cumulative preferred holders have no claim on dividends that were not declared, so the missed payment is gone and only the current dividend has priority over common. Arrears accrue only on cumulative preferred. Preferred dividends do not convert into extra shares, and, unlike missed bond interest, an omitted dividend is not a default.

A struggling company's board omits the dividend on its common stock and, in the same quarter, the company misses a scheduled interest payment on its bonds. Which statement is correct?

• a.Only the omitted dividend is a default, since common holders are the company's owners
• b.Both are defaults, because each is a payment the company promised to its investors
• c.Neither is a default unless the board has formally declared the interest payable
• d.The missed interest is a default under the bond terms; the dropped dividend is not✓

Bond interest is a contractual obligation in the indenture, so missing it is a default that gives bondholders legal remedies. A common dividend is paid only if the board declares it, so omitting one creates no default. Stockholders have no promise to be paid, interest is not discretionary like a dividend, and ownership does not turn an omitted dividend into a default.

A preferred stock has a $25 par value and pays a 6% dividend. It currently trades at $30 per share. What are its annual dividend per share and current yield?

• a.$1.50 dividend; 6.00% current yield
• b.$1.50 dividend; 5.00% current yield✓
• c.$1.80 dividend; 6.00% current yield
• d.$1.80 dividend; 7.20% current yield

The dividend is set on par, not market price: 6% x $25 = $1.50. Current yield = annual dividend / market price = $1.50 / $30 = 5.00%. A 6.00% yield would only result if the stock traded at par. A $1.80 dividend comes from wrongly applying the 6% rate to the $30 market price, and dividing that $1.80 by the $25 par gives the 7.20% figure.

An issuer has 10,000 shares of 5% cumulative preferred stock outstanding, $100 par. It has paid no preferred dividends for the last three years, and this year's dividend is also due. The board wants to pay a common dividend this year. What is the minimum total it must pay the preferred holders first?

• a.$150,000
• b.$50,000
• c.$250,000
• d.$200,000✓

Annual preferred dividend = 5% x $100 x 10,000 shares = $50,000. Cumulative preferred must receive all three years of arrears ($150,000) plus the current year ($50,000) = $200,000 before common is paid. $150,000 leaves out the current year, $50,000 treats the stock as non-cumulative, and $250,000 counts one year too many.