FINRA SIE — Securities Industry Essentials — All Questions

A bond is priced at $1,200 and has a modified duration of 5.0. Yields fall by 25 basis points. Which is the approximate change in the bond's price?

• a.An increase of about $12.50
• b.An increase of about $3.00
• c.A decrease of about $15.00
• d.An increase of about $15.00✓

Percentage change = 5.0 x 0.25% = 1.25%, which on a $1,200 price is $15.00, and the price rises because yields fell. $12.50 applies 1.25% to $1,000 par instead of the $1,200 price, $3.00 applies only 0.25%, and a decrease has the direction reversed.

An investor expects interest rates to rise over the next year and wants the bond with the least price risk. Which bond is best suited to this view?

• a.A 20-year bond with a 3% coupon
• b.A 2-year bond with a 6% coupon✓
• c.A 5-year zero-coupon bond
• d.A 10-year bond with a 6% coupon

When rates are expected to rise, the investor wants the lowest duration, which comes from the shortest maturity and the highest coupon. The 2-year 6% bond has both. A 10-year bond has a longer maturity, a 20-year 3% bond has both a longer maturity and a lower coupon, and a zero-coupon bond pays nothing until maturity, so even a 5-year zero is more price sensitive than a 2-year coupon bond.

An investor holds only 2-year bonds and 30-year bonds and owns nothing between those maturities. Which strategy does this describe?

• a.A bulleted strategy
• b.A barbell strategy✓
• c.A laddered strategy
• d.A matched-maturity strategy

A barbell concentrates holdings at both the short and long ends of the maturity range. A ladder spreads holdings evenly across many maturities, a bullet concentrates holdings at a single maturity, and a matched-maturity strategy lines up bond maturities with the date a liability is due.

Which statement about convexity is correct for an option-free bond?

• a.A yield decline raises the price by more than an equal yield rise lowers it✓
• b.For the same size change in yield, the price drop when yields rise exceeds the price rise when yields fall
• c.For any change in yield, the price changes only in proportion to the coupon rate
• d.For the same size change in yield, the price change is identical in both directions

Positive convexity means the price-yield relationship curves: a yield decline lifts the price by more than an equal yield increase lowers it. A straight-line relationship would give equal changes in both directions, and the coupon rate is only one input to price sensitivity.

Who creates Treasury STRIPS?

• a.The Federal Reserve, which issues them to carry out open market operations
• b.The Treasury, which auctions them directly to the public as zero-coupon securities
• c.Corporations, which repackage their own bonds into zero-coupon securities
• d.Dealers that separate the interest and principal of an eligible Treasury security✓

STRIPS are not issued by the Treasury. Financial institutions and government securities dealers strip the coupon and principal payments of eligible Treasury notes and bonds through the book-entry system, and each piece trades as a separate zero-coupon security. The Federal Reserve does not issue them for policy purposes, and corporate repackagings are not Treasury STRIPS.

In a Treasury auction, how does a noncompetitive bid differ from a competitive bid?

• a.A noncompetitive bidder accepts the auction yield and is filled in full✓
• b.A noncompetitive bidder pays more than competitive bidders because it receives priority
• c.A noncompetitive bidder names a yield and may be rejected if that yield is too high
• d.A noncompetitive bidder is limited to Treasury bills and may not buy notes

Noncompetitive bidders (typically individuals) do not name a yield. They accept the rate set at the auction and are assured of being filled, within the allowed limit. Competitive bidders name a yield and may receive less or nothing if the bid is too high. In a single-price auction, all successful bidders receive the same rate. Noncompetitive bids may be placed for bills, notes and bonds.

A 13-week (91-day) Treasury bill with a $10,000 face value is sold at a discount rate of 4.80% based on a 360-day year. What is the price?

• a.$9,520.00
• b.$9,878.67✓
• c.$9,880.00
• d.$9,880.33

Price = face x (1 - discount rate x days / 360) = $10,000 x (1 - 0.048 x 91 / 360) = $10,000 x 0.987867 = $9,878.67. $9,880.33 uses a 365-day year, $9,880.00 treats the bill as exactly one quarter of a year, and $9,520.00 applies a full year of discount.

An investor buys a TIPS with a $1,000 original principal and holds it to maturity. After a long period of deflation, the inflation-adjusted principal at maturity is $960. What principal is repaid at maturity?

• a.$960
• b.$980
• c.$1,000✓
• d.$1,040

At maturity a TIPS repays the greater of its inflation-adjusted principal or its original principal, so the $960 adjusted amount is replaced by the $1,000 original principal. $960 ignores that floor, $1,040 would apply the wrong sign to the adjustment, and $980 averages the two amounts.

An investor buys a Treasury STRIP in a taxable account. Which statement about taxation is correct?

• a.The investor reports no income at all until the STRIP is sold or matures
• b.The investor reports the accreted discount as interest each year, though no cash is received✓
• c.The investor reports the discount as a capital gain each year as it accretes
• d.The investor reports all the interest in the year the STRIP matures

A STRIP is a zero-coupon security, and the discount is accreted as interest income each year for federal tax purposes, which is phantom income because no payments are made before maturity. The accretion is interest, not capital gain, and it is not deferred to maturity or sale.IRC §1272

An investor wants Treasury exposure and is concerned that interest rates will rise sharply. Which Treasury security is best suited to this concern?

• a.A zero-coupon Treasury STRIP security
• b.A 30-year Treasury bond
• c.A Treasury floating rate note✓
• d.A 10-year fixed-rate Treasury note

A floating rate note's interest rate resets weekly with the 13-week bill auction rate, so its coupon rises as rates rise and its price stays close to par. A 30-year bond, a STRIP and a 10-year note all have fixed returns and suffer price declines when rates rise, with the zero-coupon STRIP hurt the most.

Which of the following is typically included in the monthly payment an investor receives from a mortgage pass-through certificate?

• a.Interest, scheduled principal, and prepayments✓
• b.Scheduled principal only, with interest paid semiannually
• c.Interest and scheduled principal only, because prepayments go to the servicer
• d.Interest only, with principal returned at maturity

A pass-through passes along the borrowers' monthly payments, net of servicing and guarantee fees: interest, scheduled principal, and any prepayments. That is why the principal balance shrinks over time and the cash flow is not a bullet at maturity.

An investor owns a GNMA pass-through bought at a premium. Mortgage rates fall sharply. What is the most likely result?

• a.Prepayments speed up, and the premium paid becomes more valuable
• b.Prepayments slow down, and the average life of the security lengthens
• c.Prepayments are unchanged, because the security is guaranteed by the government
• d.Prepayments speed up, and principal is reinvested at lower rates✓

When mortgage rates fall, homeowners refinance and prepayments rise, which shortens the average life, exposes the holder to contraction and reinvestment risk, and hurts those who paid a premium. Slower prepayments and extension risk happen when rates rise. The government guarantee covers timely payment, not prepayment speed.

Interest rates fall sharply, and prepayments on a mortgage pool accelerate. What is the likely effect on the value of an interest-only (IO) strip and a principal-only (PO) strip from that pool?

• a.Both strips rise
• b.The IO strip falls and the PO strip rises✓
• c.The IO strip rises and the PO strip falls
• d.Both strips fall

An IO strip depends on interest from the outstanding balance, which shrinks faster when prepayments rise, so its value falls. A PO strip receives principal, which comes back sooner at par, so its value rises. The two strips move in opposite directions.

A mortgage pool is prepaying at 150% PSA. In month 20 of the pool's life, which is the annualized prepayment rate (CPR)? (100% PSA is 0.2% CPR in month 1, rising 0.2% each month to 6% in month 30.)

• a.2.7%
• b.4.0%
• c.9.0%
• d.6.0%✓

At 100% PSA, month 20 has a CPR of 20 x 0.2% = 4.0%. At 150% PSA, multiply by 1.5: 4.0% x 1.5 = 6.0%. 4.0% is the 100% PSA rate, 9.0% is the peak for 150% PSA (reached in month 30), and 2.7% divides by 1.5 instead of multiplying.

Which description fits the Z-tranche (accrual tranche) of a CMO?

• a.It accrues interest to principal and gets no cash until earlier tranches retire✓
• b.It has the most stable cash flows because it follows a planned amortization schedule
• c.It receives only the interest from the mortgages with no principal
• d.It receives only principal prepayments, which makes it rise in value when rates rise

A Z-tranche is paid last: it accrues interest like a zero-coupon bond that adds to its principal balance until the earlier tranches have been retired, so it has the longest duration. Interest-only describes an IO strip, a planned schedule describes a PAC, and a principal-only strip does not benefit when rates rise.

Which of the following is an asset-backed security (ABS) rather than a mortgage-backed security?

• a.A security backed by a pool of auto loans✓
• b.A CMO tranche backed by a pool of GNMA certificates
• c.A security backed by a pool of 30-year fixed-rate mortgages
• d.A security backed by FHA-insured mortgages

ABS are backed by consumer or business receivables such as auto loans, credit card balances or student loans. The other three choices are all backed by mortgages, so they are mortgage-backed securities.

What does a qualified legal opinion from municipal bond counsel indicate?

• a.The opinion confirms the bonds are backed by the issuer's full faith and credit
• b.The opinion is conditional or subject to qualifications✓
• c.The opinion confirms the bonds are exempt from state taxes but not federal taxes
• d.The opinion was written by counsel for the underwriter and not the issuer

A qualified (or reasoned) opinion is conditional or subject to qualifications, in contrast to the traditional unqualified opinion, which states that the bonds are valid and the interest is tax-exempt with no reservations. It does not specify which taxes apply, who retained counsel, or the security pledged.

Which municipal offering must an underwriter handle in compliance with SEC Rule 15c2-12 (assuming no exemption applies)?

• a.A $500,000 offering sold to a single bank
• b.A $750,000 public offering in $5,000 denominations to retail investors
• c.A $900,000 public offering in $1,000 denominations to retail investors
• d.A $5 million public offering in $5,000 denominations✓

Rule 15c2-12 applies to primary offerings of municipal securities with an aggregate principal amount of $1,000,000 or more, which includes the $5 million offering. The other offerings are each below that threshold.SEC Rule 15c2-12

Under a continuing disclosure undertaking required by Rule 15c2-12, the issuer must file notice of a material event, such as a rating change, with the MSRB's EMMA system within what period?

• a.At the end of the issuer's next fiscal year
• b.5 business days after the event
• c.10 business days after the event✓
• d.Within 30 calendar days after the event

The rule requires event notices to be submitted to EMMA in a timely manner, not in excess of 10 business days after the event. A 30-day window and a fiscal-year window are too long, and 5 business days is shorter than the rule requires.SEC Rule 15c2-12

A municipal bond is insured by a bond insurer. What does the insurance protect against?

• a.The risk that interest becomes subject to federal income tax
• b.The risk that the bond's market price falls when interest rates rise
• c.The risk that the issuer misses a scheduled payment of interest or principal on the bonds✓
• d.The risk that the bond is called before maturity at the issuer's option

Municipal bond insurance guarantees timely payment of interest and principal if the issuer defaults. It does not protect against market price changes, calls or a loss of tax-exempt status.

A municipal issuer sells new bonds and places the proceeds in an escrow account invested in Treasury securities, to pay off an outstanding issue on its first call date. How is the outstanding issue described?

• a.Moral obligation
• b.Subordinated
• c.Pre-refunded✓
• d.Pass-through

Bonds whose payment is secured by an escrow of Treasury securities until the call date are pre-refunded. They are typically viewed as extremely safe, and they trade on a yield to the call date. Moral obligation and subordination describe different credit arrangements.

A state housing finance agency issues revenue bonds that are backed by a moral obligation pledge from the state. What does the pledge mean?

• a.The state is legally required to pay debt service from its general fund
• b.The bonds are secured by a mortgage on property owned by the agency
• c.The state legislature may, but need not, appropriate funds to cover a shortfall in debt service✓
• d.The bonds are guaranteed by the federal government

A moral obligation is a non-binding commitment: the legislature is expected to consider an appropriation to cover a shortfall, but it has no legal duty to do so. That makes it weaker than a full faith and credit pledge. It is not a federal guarantee, and it is not a lien on property.

A city builds a new sewer line and issues bonds that will be repaid from charges on the owners of the properties that benefit from it. Which type of bond is this, and what is the main risk?

• a.A special assessment bond, with the risk that the city sells the sewer line
• b.A general obligation bond, with the risk that voters reject a tax increase
• c.A revenue bond, with the risk that fewer people use the sewer line
• d.A special assessment bond, with the risk that the property owners fail to pay assessments✓

Special assessment bonds are repaid from assessments levied on the benefited property owners, so the credit depends on those owners paying. A GO bond is backed by general taxing power, and a revenue bond is repaid from operating revenue of the facility, such as user charges.

An investor in a high tax bracket who pays the alternative minimum tax is considering four municipal bonds. For which is the interest most likely to be an AMT preference item?

• a.A revenue bond that finances a public water system
• b.A general obligation bond that finances a public school
• c.An industrial development revenue bond that finances a private company's factory✓
• d.A general obligation bond that finances a municipal road

Interest on certain private activity bonds, such as industrial development revenue bonds that benefit a private user, can be an AMT preference item. Bonds that finance essential governmental functions, such as schools, roads and public water systems, are not.IRC §57(a)(5)

A state transportation department issues short-term notes that will be repaid from federal highway grants it has been awarded but not yet received. What type of note is this?

• a.A revenue anticipation note
• b.A grant anticipation note✓
• c.A bond anticipation note
• d.A tax and revenue anticipation note

A grant anticipation note (GAN) is repaid from expected grant money. A BAN is repaid from the proceeds of a later bond sale, a TRAN from expected taxes and revenues, and a RAN from expected revenues such as tolls.

A city offers $10 million of bonds for competitive sale. Bidders submit sealed bids using net interest cost (NIC). Bidder A offers total interest of $4,150,000 and a $50,000 premium. Bidder B offers $4,100,000 of total interest and a $30,000 discount. Bidder C offers $4,200,000 and a $120,000 premium. Bidder D offers $4,090,000 and no premium or discount. Which bidder wins the award?

• a.Bidder B
• b.Bidder C✓
• c.Bidder A
• d.Bidder D

NIC = total interest + discount - premium. A: $4,150,000 - $50,000 = $4,100,000. B: $4,100,000 + $30,000 = $4,130,000. C: $4,200,000 - $120,000 = $4,080,000. D: $4,090,000. The lowest NIC is C's, so it wins the award, even though C has the highest stated interest. D has the lowest stated interest but not the lowest cost.

Which statement distinguishes a negotiated municipal underwriting from a competitive one?

• a.In a negotiated underwriting, the issuer awards the bonds to the lowest bidder from sealed bids
• b.In a negotiated underwriting, the issuer must choose a syndicate managed by a bank
• c.In a negotiated underwriting, the issuer selects the underwriter in advance and negotiates the terms of the sale✓
• d.In a negotiated underwriting, the issuer sells the bonds directly to investors without an underwriter

In a negotiated sale the issuer picks the underwriter before the sale and they negotiate price and terms. In a competitive sale, underwriters submit sealed bids and the issuer awards the bonds to the lowest TIC or NIC bidder. A direct placement avoids an underwriter, and no rule requires a bank to manage the syndicate.

A dealer sells $5 million of Treasury securities to a bank and agrees to repurchase them the next day at a slightly higher price. How is the transaction described from the bank's side?

• a.A repurchase agreement with a dealer
• b.A commercial paper purchase
• c.A federal funds loan in the open market
• d.A reverse repurchase agreement✓

The party that sells securities and agrees to buy them back is in a repo; the party on the other side, buying the securities with an agreement to sell them back, is in a reverse repo. A plain repo is the dealer's side of this trade. Federal funds are overnight reserve loans between banks and are not secured by Treasuries in this way, and commercial paper is unsecured corporate debt.

An investor holds $400,000 in negotiable certificates of deposit at one FDIC-insured bank, all in the investor's individual name. The bank fails. What is the maximum amount covered by FDIC insurance?

• a.$400,000
• b.$200,000
• c.$250,000✓
• d.$100,000

FDIC insurance covers $250,000 per depositor, per insured bank, per ownership category. All the CDs are in one category at one bank, so the coverage is $250,000. $400,000 treats each CD as separately insured, and $100,000 and $200,000 reflect old or invented limits.12 U.S.C. §1821(a)

A U.S. importer buys goods from a foreign exporter and pays with a time draft that the importer's bank accepts, promising to pay the holder at maturity. The exporter may sell the accepted draft at a discount before maturity. What money market instrument is this?

• a.A repurchase agreement, in which the exporter sells the draft and agrees to buy it back
• b.A negotiable certificate of deposit, which the importer's bank issued to a depositor
• c.Commercial paper, which is backed only by the importer's own credit
• d.A banker's acceptance, which is backed by the credit of the bank that accepted it✓

A time draft that a bank has accepted becomes a banker's acceptance, a short-term discount instrument that finances trade and is backed by the accepting bank's credit. Commercial paper is an unsecured note of the issuer itself, a negotiable CD is a deposit that a bank issues to a depositor, and a repurchase agreement involves a sale with a commitment to repurchase, which does not describe the exporter's sale of the draft.

What are Eurodollars?

• a.Dollar-denominated bonds issued by European governments
• b.Euro-denominated deposits held at U.S. banks
• c.Dollar deposits at banks outside the United States✓
• d.Dollar loans between banks made through the Federal Reserve

Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of U.S. banks, outside U.S. banking regulation. Euro deposits at U.S. banks reverse the currency and location, and interbank loans through the Fed describe federal funds.

An investor buys a zero-coupon corporate bond in a taxable account. Which statement about taxation is correct?

• a.The investor owes tax each year only on the cash interest that is actually received
• b.The investor owes tax each year on the accreted OID, though no interest is paid✓
• c.The investor owes no tax if the bond is held to maturity
• d.The investor owes tax only when the bond matures, because no interest is paid before then

OID on a zero-coupon bond is taxed annually as interest income as it accrues, and this is phantom income because no cash is received until maturity. The accretion also increases the investor's cost basis. Tax deferral to maturity applies in tax-deferred accounts, not in a taxable account.IRC §1272

An investor buys a 20-year zero-coupon corporate bond at $400 per $1,000 face in a taxable account and reports $60 of OID over the next 3 years. The investor then sells it for $520. What is the capital gain?

• a.$120
• b.$520
• c.$60✓
• d.$180

The OID reported each year increases the cost basis: $400 + $60 = $460. The capital gain on a $520 sale is $520 - $460 = $60. $120 ignores the basis adjustment, $180 adds the OID again, and $520 is the whole sale price.IRC §1272

An investor buys a tax-exempt municipal bond with exactly 4 years and 6 months left at 98.75 ($987.50 per $1,000 bond). Under the de minimis rule, how is the discount treated at maturity?

• a.As ordinary income, because the $12.50 market discount exceeds the $10 de minimis amount✓
• b.As tax-exempt interest, because the bond is a municipal bond
• c.As a capital gain, because the bond was bought on the secondary market
• d.As a capital gain, because the $12.50 discount exceeds the $10 de minimis amount

The de minimis amount = 0.25% x redemption value x full years to maturity = 0.0025 x $1,000 x 4 = $10. The market discount is $1,000 - $987.50 = $12.50, which exceeds $10, so it is not de minimis and the accrued market discount is taxed as ordinary income. A discount below the threshold would be treated as capital gain. Market discount is not tax-exempt interest.IRC §1278(a)(2)

An investor buys a tax-exempt municipal bond at a premium. How is the premium treated?

• a.It is added to the cost basis and recovered when the bond matures
• b.It must be amortized, with no deduction, and reduces cost basis✓
• c.It is ignored, and the investor reports a capital loss at maturity
• d.It may be amortized and deducted each year against ordinary income

For tax-exempt bonds, the premium is amortized over the life of the bond and reduces cost basis each year, but the amortization is not deductible because the interest is tax-exempt. As a result, the basis equals par at maturity and there is no capital loss. The other statements get either the deduction or the basis effect wrong.IRC §171

An investor buys a corporate bond for $970, receives $60 of coupon interest while holding it, then sells it for $1,010. How are the proceeds taxed?

• a.$60 as a capital gain and $40 as ordinary income
• b.$40 as ordinary income and $60 as capital gain
• c.$100 as ordinary interest income
• d.$60 as ordinary interest income and $40 as a capital gain✓

Coupon interest is ordinary income: $60. The sale price less the cost is a capital gain: $1,010 - $970 = $40. The other choices swap the types of income or treat everything as ordinary income.

An investor holds one XYZ 80 call covering 100 shares. XYZ then declares a 2-for-1 stock split. After the standard adjustment for the split, what does the investor hold?

• a.Two XYZ 80 calls, each covering 100 shares
• b.One XYZ 80 call covering 100 shares, left unchanged
• c.One XYZ 160 call covering 100 shares
• d.Two XYZ 40 calls, each covering 100 shares✓

In a 2-for-1 split the stock price falls to about half while holders end up with twice as many shares, so the option is adjusted to keep its economics the same: the number of contracts doubles and the strike is halved, which gives two 40 calls. Leaving the call at one 80 contract would turn a near-the-money call into a deep out-of-the-money one overnight. A 160 strike moves the wrong way and would gut the call's value just as the stock price halves. Doubling the contracts but keeping the 80 strike would give the holder the right to buy twice as many shares at a price now far above the market.OCC By-Laws, Article VI, Section 11

A customer holds one index call with a 5,000 strike and a $100 multiplier. The option is exercised when the index settles at 5,040. What happens at settlement?

• a.The writer pays $4,000 in cash, and no stock is delivered✓
• b.The writer delivers the index's component stocks to the holder at the strike
• c.The writer delivers the index's component stocks, worth $504,000
• d.The writer pays the holder $40 in cash, and no stock is delivered

Index options are cash settled. The amount owed is (index level minus strike) times the multiplier: (5,040 - 5,000) x $100 = $4,000. Paying only $40 forgets the multiplier. An index is not a deliverable asset, so nobody receives the component stocks, whether at the strike or at their full value. The $504,000 figure is the index value times the multiplier, which describes the size of the exposure, not what the writer pays on exercise.Characteristics and Risks of Standardized Options (ODD)

On Monday, a regular business day, a customer exercises an equity call on XYZ and the exercise is assigned to a short customer. Under the standard settlement cycle for exercises of equity options, when do the shares and payment change hands?

• a.On Wednesday, two business days after exercise
• b.On Tuesday, the next business day✓
• c.On Monday, the same day as the exercise
• d.On Thursday, three business days after exercise

Exercises of equity options settle on the next business day (T+1), the same cycle that applies to stock trades, so a Monday exercise settles on Tuesday. Wednesday reflects the former T+2 cycle and Thursday the older T+3 cycle, both of which have been replaced. Same-day settlement is not the standard: the shares have to be delivered and paid for through the clearing process, which takes a business day.OCC By-Laws, Article VI

A firm approves a customer's account for standardized options trading on March 3. Which statement correctly describes the firm's timing obligations under FINRA Rule 2360?

• a.The ODD may be sent with the first trade confirmation, and the signed account agreement is due by March 18
• b.The ODD must be delivered at or before approval on March 3, and the signed agreement is due by March 18✓
• c.The ODD must be delivered at or before approval on March 3, and the signed account agreement is due by April 2
• d.The ODD must be delivered by March 18, and the signed account agreement must be on file at or before approval on March 3

Rule 2360 has two separate clocks. The options disclosure document (ODD) must be furnished at or before the time the account is approved for trading, so March 3 at the latest. The customer's written account agreement, in which the customer agrees to be bound by the applicable rules, must be obtained within 15 days after approval, which is March 18. Reversing the two deadlines is wrong because the ODD comes first and the agreement can follow. A 30-day agreement window, ending April 2, is longer than the rule allows. Delaying the ODD until the first confirmation is too late, since the customer must see the risks before the account can trade.FINRA Rule 2360(b)(11) and (b)(16)(D)

An investor wants an exchange-listed put on ABC that expires about 20 months from now. Which statement is correct?

• a.It would be a LEAPS contract, which can only be exercised at expiration
• b.It cannot exist, because listed options may not expire more than nine months from listing
• c.It must be an over-the-counter contract, because listed options expire within one year
• d.It would be a LEAPS contract, which lists with more than nine months until expiration✓

LEAPS (Long-term Equity AnticiPation Securities) are exchange-listed calls and puts with expirations of more than nine months when listed, so a 20-month put is exactly what LEAPS are for. Listed options are not capped at nine months; that figure is the point above which an option is called a LEAPS contract. Nor must a long-dated option be over the counter, because LEAPS are standardized and cleared by OCC like other listed options. LEAPS on stocks are American style and can be exercised any time before expiration, so the claim that they exercise only at expiration is wrong.Characteristics and Risks of Standardized Options (ODD)

A customer is short five ABC 50 calls, and the holder of an ABC 50 call at another firm exercises. How is the assignment handled?

• a.OCC randomly picks a clearing member with shorts, which then assigns a customer at random or first-in, first-out✓
• b.Only uncovered writers can be assigned, and covered writers are passed over until expiration
• c.OCC assigns the writer who sold the contract earliest, ranked by trade date across all firms
• d.The exerciser chooses which writer to assign after reviewing the short positions held at each firm

When a holder exercises, OCC randomly assigns the exercise notice to a clearing member that carries short positions in the same series. The clearing member then assigns it to one of its short customers using a random or first-in, first-out method that it has disclosed. OCC does not rank writers by trade date across the market, and the exerciser has no say in who is assigned. Covered writers are not exempt, since a short call is subject to assignment whether or not the writer owns the stock.OCC By-Laws, Article VI

Open interest in an option series is 400 contracts. Trader A sells 50 contracts to open to Trader B, who is buying to open. Then Trader C sells 30 contracts to close to Trader D, who is buying to open. What is the open interest afterward?

• a.500 contracts
• b.480 contracts
• c.450 contracts✓
• d.420 contracts

Open interest counts contracts outstanding that have not been closed out or exercised. The first trade creates 50 new contracts because both sides are opening, so open interest rises to 450. In the second trade, C is closing an existing long position and D is opening a new one, so a contract merely changes hands and open interest does not move. A total of 500 would count both the long and the short side of the new contracts. A total of 480 treats the transfer as new contracts, and 420 treats C's closing sale as reducing the total even though D takes over the position.Characteristics and Risks of Standardized Options (ODD)

An investor buys one XYZ 50 put for a premium of $3.50. Ignoring commissions, what is the maximum possible gain on this position?

• a.$4,650✓
• b.$5,350
• c.$5,000
• d.$350

The put buyer profits most if the stock falls to zero, at which point the put is worth the full strike price of $50 per share. The gain is the strike minus the premium paid: ($50 - $3.50) x 100 = $4,650. The $5,000 figure ignores the premium that was paid to get the position. The $5,350 figure adds the premium instead of subtracting it. The $350 figure is the most the buyer can lose, not the most the buyer can gain.

An investor writes one uncovered ABC 40 call and collects a premium of $2.25. At expiration ABC is trading at $46. Ignoring commissions, what is the result of the position?

• a.A loss of $375✓
• b.A loss of $600
• c.A loss of $825
• d.A profit of $225

The call is in the money by $6 at expiration (46 - 40), so the writer must deliver at 40 stock worth 46, a loss of $6 per share before the premium. The premium collected offsets $2.25 of that, so the net loss is ($6.00 - $2.25) x 100 = $375. A $600 loss ignores the premium. A $825 loss adds the premium instead of subtracting it. A $225 profit would be the result only if the call expired worthless, which it does not because ABC finished above the strike.

An investor buys 100 shares of a stock at $52 and sells one 55 call for $2.50 against the position. The call is assigned at expiration. What is the investor's total profit on the position, ignoring commissions?

• a.$800
• b.$550✓
• c.$250
• d.$300

When the call is assigned, the shares are delivered at the 55 strike. The stock gain is ($55 - $52) x 100 = $300, and the investor also keeps the $2.50 x 100 = $250 premium, so the total profit is $550. This is also the most the position can earn, because the call caps the sale price at 55. The $300 figure leaves out the premium. The $250 figure leaves out the gain on the stock. The $800 figure counts the premium twice.

An investor buys 100 shares of a stock at $38 and, to limit risk, buys one 35 put for $1.60. Ignoring commissions, what is the maximum loss on the combined position?

• a.$300
• b.$160
• c.$460✓
• d.$3,800

With the put in place, the investor can always sell at 35, so the stock loss is capped at ($38 - $35) x 100 = $300. The put cost another $1.60 x 100 = $160, which is lost whatever happens. The maximum loss is therefore $300 + $160 = $460. A $300 answer forgets the cost of the put. A $160 answer counts only the premium. A $3,800 answer is the loss from the stock going to zero with no protection at all.

An investor buys one DEF 60 call at a premium of $3.20. Before expiration DEF rallies and the premium rises to $5.70, so the investor sells the call to close. Ignoring commissions, what is the result?

• a.A profit of $890
• b.A profit of $570
• c.A profit of $130
• d.A profit of $250✓

Selling the option to close realizes the change in premium: ($5.70 - $3.20) x 100 = $250. The investor never exercises, so strike prices do not enter the calculation. The $570 figure is the sale proceeds without subtracting the $320 cost. The $890 figure adds the buying and selling premiums together. The $130 figure does not come from any correct step and understates the gain.

An investor writes one JKL 45 put for a premium of $2.60. JKL falls and the put is assigned. What is the investor's effective cost per share for the 100 shares purchased, ignoring commissions?

• a.$45.00
• b.$47.60
• c.$42.40✓
• d.$2.60

When a put writer is assigned, the writer must buy the stock at the strike price of 45. The premium already collected reduces the net cost: $45.00 - $2.60 = $42.40 per share. Adding the premium ($47.60) is the wrong direction, because the premium was received, not paid. Paying exactly $45.00 ignores the premium. The $2.60 figure is just the premium and has nothing to do with the cost of the shares.

An investor writes one uncovered MNO 65 call for a premium of $3.10. At what stock price at expiration does the writer break even, ignoring commissions?

• a.$61.90
• b.$68.10✓
• c.$71.20
• d.$65.00

A call writer starts to lose money once the stock rises enough to wipe out the premium collected, so break-even is the strike plus the premium: $65.00 + $3.10 = $68.10. Strike minus premium ($61.90) is the break-even for a put buyer or writer, not a call. At the strike ($65.00) the call is only at the money, and the writer is still ahead by the $3.10 premium. The $71.20 figure double-counts the premium.