FINRA SIE — Securities Industry Essentials — All Questions

A municipal bond described as 'triple tax-exempt' provides interest that is free from:

• a.State and local income taxes but not from federal income tax
• b.Federal income tax and the AMT, but not state or local tax
• c.Federal, state, and local income taxes for residents of the issuing state✓
• d.Federal income tax, capital gains tax, and federal estate tax

'Triple tax-exempt' means the interest is generally free from federal income tax and from state and local income taxes, which applies when the investor lives in the state (and, for local tax, the locality) that issued the bond. Exemption from state and local tax alone still leaves federal tax payable, so that is not triple exemption. Federal exemption without state or local exemption is only a single exemption, and interest on some private-activity bonds is also subject to the AMT. The exemption covers interest only: capital gains from selling the bond remain taxable, and federal estate tax is not waived.IRC §103(a) (26 U.S.C. 103)

A city wants to finance a new municipal water and sewer system, and plans to repay bondholders only from the fees charged to users of that system. Which type of bond is this?

• a.A U.S. Treasury bond
• b.A revenue bond✓
• c.A general obligation bond
• d.A corporate debenture

Because repayment comes solely from the user fees generated by the water and sewer facility rather than from tax revenue, this is a revenue bond. A general obligation bond would instead be backed by the city's taxing power and typically require voter approval.MSRB Rules

A key tax feature of a direct participation program (DPP) is that it:

• a.Passes income, gains, losses, and deductions directly through to the investors✓
• b.Guarantees each investor a fixed quarterly dividend regardless of the program's results
• c.Provides interest income exempt from both federal and state income tax
• d.Is taxed as a C corporation, paying income tax at the entity level

A DPP, typically structured as a limited partnership, is a flow-through (pass-through) entity: it pays no tax at the entity level, and its income, gains, losses, and deductions flow directly to the investors' individual tax returns. This flow-through of tax items, along with potential deductions, is a defining feature of DPPs.

In a direct participation program organized as a limited partnership, the limited partners:

• a.Manage the day-to-day operations of the partnership's business
• b.Have liability limited to the amount of their investment✓
• c.Guarantee the general partner's obligations to lenders
• d.Are personally liable for all debts of the partnership

Limited partners are passive investors whose liability is limited to their invested capital, and they do not take part in day-to-day management. The general partner runs the business and bears unlimited liability. This limited liability, combined with pass-through taxation, defines the limited partnership structure of most DPPs.

Which of the following is a common type of direct participation program?

• a.A real estate limited partnership✓
• b.A U.S. Treasury note
• c.An open-end money market mutual fund
• d.A federally insured bank certificate of deposit

Common DPPs include real estate, oil and gas, and equipment-leasing limited partnerships, which let investors participate directly in the cash flow and tax consequences of the underlying venture. CDs, money market funds, and Treasuries are not DPPs because they lack the direct pass-through partnership structure.

Which is a primary risk that a registered representative should disclose about most direct participation programs?

• a.Their principal is federally guaranteed against loss by the SEC
• b.They are illiquid, with limited or no secondary market for the interests✓
• c.Their interests trade actively on a national securities exchange each day
• d.They provide a guaranteed monthly income to every limited partner

DPP interests are generally illiquid because there is little or no active secondary market, so investors may be unable to sell readily and should plan to hold for the long term. Combined with their speculative nature and reliance on the general partner, illiquidity makes DPPs suitable only for investors who can bear such risks.

Hedge funds are typically sold through private placements and are generally limited to:

• a.Accredited investors and other qualified, sophisticated investors✓
• b.Only tax-exempt charitable foundations and state public pension plans
• c.Investors under age 59 who hold the fund inside a traditional IRA
• d.Any retail investor who signs and returns the fund's prospectus

Hedge funds are usually offered privately under Regulation D of the Securities Act of 1933 and are restricted to accredited or otherwise qualified, sophisticated investors who meet income or net-worth standards. This exemption from full registration reflects the funds' complex, higher-risk strategies and limited disclosure.Securities Act of 1933

Compared with a registered open-end mutual fund, a hedge fund typically:

• a.Offers daily redemption at net asset value to any retail investor who requests it
• b.Is prohibited by the Investment Company Act from charging performance-based fees
• c.Is subject to the same strict leverage and diversification limits as a 1940 Act fund
• d.Uses aggressive strategies, may employ leverage and short selling, and often imposes lock-up periods✓

Hedge funds pursue aggressive, flexible strategies that can include leverage, derivatives, and short selling, and they frequently charge performance-based fees and restrict withdrawals through lock-up periods. Because they are lightly regulated and can be illiquid and high-risk, they suit only sophisticated investors, unlike heavily regulated mutual funds.Investment Company Act of 1940 §3(c)(1) and §3(c)(7) (15 U.S.C. 80a-3(c))

Under the forward pricing rule, an order to buy or redeem open-end mutual fund shares is executed at:

• a.A price negotiated between the buyer and the selling dealer
• b.The next NAV calculated after the order is received✓
• c.The average NAV over the prior five business days
• d.The NAV calculated at the previous day's market close

Forward pricing requires that mutual fund purchase and redemption orders be filled at the next net asset value computed after the order is received, typically at the end of that business day. This prevents investors from trading on a stale, already-known price and is required under the Investment Company Act of 1940.Investment Company Act of 1940

A 12b-1 fee charged by a mutual fund is used to cover:

• a.Federal and state income taxes owed by the fund on its earnings
• b.Ongoing distribution and marketing costs, deducted annually from fund assets✓
• c.A one-time front-end sales charge collected at the time of purchase
• d.The custodian's safekeeping of fund securities and cash balances

A 12b-1 fee is an annual charge, deducted from fund assets, that pays for distribution and marketing expenses such as advertising and compensation to selling brokers. Because it is an ongoing asset-based fee, it raises a fund's expense ratio and reduces investor returns over time; a 'no-load' fund's 12b-1 fee is limited to 0.25%.Investment Company Act of 1940

A mutual fund's expense ratio measures:

• a.Annual operating expenses as a percentage of the fund's average net assets✓
• b.The fund's annual dividend yield based on its net asset value
• c.The front-end sales load as a percentage of the public offering price
• d.The bid-ask spread quoted on the fund's shares in the market

The expense ratio expresses a fund's annual operating costs, including management fees, 12b-1 fees, and administrative expenses, as a percentage of its average net assets. A higher expense ratio directly reduces investor returns, so comparing expense ratios is important when selecting among similar funds.Investment Company Act of 1940

Under the 75-5-10 test, a mutual fund may call itself 'diversified' if, with 75% of its assets, it invests no more than:

• a.10% of assets in any one issuer and owns up to 5% of an issuer's outstanding voting stock
• b.5% of assets in any one issuer and owns no more than 10% of an issuer's voting stock✓
• c.50% of assets in U.S. government securities and no more than 25% in any one issuer
• d.25% of assets in any one issuer, with no limit at all on the voting stock owned

To be labeled diversified under the Investment Company Act of 1940, at least 75% of a fund's assets must be invested so that no more than 5% is in any single issuer and the fund owns no more than 10% of any issuer's voting securities. The remaining 25% is unrestricted, giving the fund some concentration flexibility.Investment Company Act of 1940

A retail money market mutual fund generally seeks to maintain a stable net asset value of:

• a.$1.00 per share✓
• b.$100.00 per share
• c.A floating NAV, as institutional prime funds use
• d.$10.00 per share

Under SEC Rule 2a-7(c)(1), government and retail money market funds may use amortized cost or penny rounding to hold a stable price, which they typically hold at $1.00 per share, with earnings paid out as dividends. A floating NAV is what institutional prime money market funds use, not retail funds. Share prices of $10 or $100 are not money market conventions. Money market funds invest in short-term, high-quality debt and are generally low risk, but they are not federally insured, so a stable $1.00 value is a goal rather than a guarantee.17 CFR 270.2a-7(c)(1)

An investor is concerned that rising interest rates will reduce the value of a fund's holdings. This concern is most relevant to which fund?

• a.An equity growth fund
• b.A commodity fund
• c.A money market fund holding only overnight paper
• d.A long-term bond fund✓

Interest rate risk is the danger that rising rates reduce the market value of existing fixed-income securities, and it is greatest for funds holding long-maturity bonds. A long-term bond fund is therefore the most exposed, while money market funds with very short maturities have minimal interest rate risk.Investment Company Act of 1940

A sector fund that invests almost entirely in technology companies primarily exposes investors to:

• a.Interest rate risk alone, because technology firms borrow heavily
• b.Very low volatility and minimal risk, because technology earnings are stable
• c.Concentration risk, because performance depends heavily on one industry✓
• d.No market risk at all, because the fund is diversified across dozens of issuers

A sector (specialized) fund concentrates its holdings in a single industry, so investors face higher concentration risk: gains and losses hinge on the fortunes of that one sector rather than being spread across the broader market. This can boost returns when the sector thrives but magnifies losses when it declines.Investment Company Act of 1940

An index fund is designed to:

• a.Guarantee a fixed annual return to shareholders no matter how the broad market performs
• b.Outperform its benchmark by having a manager actively select undervalued stocks each year
• c.Match the performance of a specific market index by holding its component securities✓
• d.Invest only in short-term money market instruments that mature within thirteen months

An index fund follows a passive strategy, holding the securities that make up a target index (such as the S&P 500) in order to track that index's return rather than beat it. This passive approach typically results in lower turnover and lower expense ratios than actively managed funds.Investment Company Act of 1940

Under FINRA rules, the maximum sales charge on the purchase of open-end mutual fund shares generally may not exceed:

• a.6.25% of the offering price
• b.5.0% of NAV
• c.7.0% of NAV
• d.8.5% of the offering price✓

FINRA limits the maximum sales charge on mutual fund shares to 8.5% of the public offering price. To charge the full 8.5%, a fund must offer certain shareholder benefits such as breakpoints, rights of accumulation, and dividend reinvestment at NAV; otherwise the maximum is lower.FINRA Rule 2341

When an investor redeems open-end mutual fund shares, the fund must generally send payment within:

• a.Ninety days
• b.Seven days✓
• c.One day
• d.Thirty days

Under the Investment Company Act of 1940, an open-end fund must redeem shares at NAV and pay the proceeds within seven days of receiving the redemption request. This redeemability at NAV is a defining feature of open-end funds and provides investors with reliable liquidity.Investment Company Act of 1940

Rights of accumulation allow a mutual fund investor to:

• a.Redeem accumulated shares free of any capital gains tax once they have been held over one year
• b.Count the current value of existing holdings toward reaching a breakpoint on new purchases✓
• c.Buy Class B shares at the Class A price with no contingent deferred sales charge on redemption
• d.Receive fund dividends in cash at a reduced tax rate instead of reinvesting them in new shares

Rights of accumulation let an investor qualify for a breakpoint (reduced sales charge) by adding the current value of shares already owned to a new purchase. Unlike a Letter of Intent, there is no time limit and no obligation to invest a set future amount; the benefit accrues as holdings grow.FINRA Rule 2341(b)(7) and (d)(1)(B)

When a customer purchases newly issued open-end mutual fund shares, the customer must be provided:

• a.A research report from an independent analyst
• b.Nothing, because mutual funds are exempt from disclosure
• c.A signed suitability guarantee from the fund manager
• d.A current prospectus, at or before the sale✓

Because open-end mutual fund shares are continuously issued as new securities, they must be sold with a current prospectus delivered at or before the completion of the sale, as required under the Securities Act of 1933. The prospectus discloses the fund's objectives, risks, fees, and expenses so the investor can make an informed decision.Securities Act of 1933

The taxable-equivalent yield of a municipal bond is used to:

• a.Compare a tax-exempt muni yield to the pre-tax yield a taxable bond must offer to be equally attractive✓
• b.Determine the bond's yield to maturity after subtracting the dealer's markup from the purchase price
• c.Calculate the state and local income tax a nonresident investor owes on out-of-state municipal interest
• d.Measure the bond's after-tax yield by subtracting the federal income tax owed on each coupon payment

Taxable-equivalent yield converts a tax-free municipal yield into the higher pre-tax yield a taxable bond would need in order to leave an investor with the same after-tax return. It lets an investor compare munis and taxable bonds on an apples-to-apples basis, and the higher the investor's tax bracket, the larger the advantage of the muni.

Interest paid on most general obligation municipal bonds is:

• a.Exempt from federal income tax✓
• b.Subject to federal capital gains tax as it is received
• c.Fully taxable at the federal level but exempt from state tax
• d.Taxed only if the bond is sold before maturity

The interest (coupon) on most municipal bonds is exempt from federal income tax, which is their primary appeal. It may also be exempt from state and local tax for residents of the issuing state. Capital gains on munis, however, remain taxable.

A 'bank-qualified' municipal bond is one that:

• a.Is guaranteed by a commercial bank rather than by a municipal bond insurer
• b.Automatically qualifies for the highest credit rating from the rating agencies
• c.May be purchased only by federally chartered commercial banks and thrifts
• d.Is issued by a small issuer and gives banks a partial tax advantage on the cost of carrying it✓

A bank-qualified municipal bond is issued by an issuer that reasonably expects to sell no more than a set annual amount of tax-exempt debt. This designation lets banks deduct a portion of the interest cost of carrying the bonds, making the bonds more attractive to banks and often lowering the issuer's borrowing cost.

A 529 college savings plan offers which key federal tax benefit?

• a.Earnings grow tax-deferred and qualified education withdrawals are federally tax-free✓
• b.Withdrawals are federally tax-free after five years, whatever the money buys
• c.Earnings are taxed annually at a reduced federal rate of 10% on gains
• d.Contributions are deductible on the federal income tax return up to $2,000

In a 529 plan, contributions are made with after-tax dollars, but earnings grow tax-deferred and withdrawals used for qualified education expenses are free from federal income tax. Nonqualified withdrawals of earnings are taxed and generally hit with a 10% penalty.

An ABLE account is designed primarily to:

• a.Fund private K-12 tuition and college costs for any family regardless of income, with the same deduction as a 529 plan
• b.Replace an employer 401(k) for self-employed persons by allowing unlimited pre-tax salary deferrals each year
• c.Let eligible individuals with disabilities save tax-advantaged funds for disability expenses without losing certain benefits✓
• d.Provide tax-free retirement income to any worker over age 50 who has already used up the annual IRA limits

An ABLE (Achieving a Better Life Experience) account lets eligible individuals whose disability began before a set age save and invest money that grows tax-deferred, with tax-free withdrawals for qualified disability expenses. Balances up to a threshold do not disqualify the beneficiary from means-tested benefits such as Medicaid or SSI.

The debt service on a municipal revenue bond is paid from:

• a.The income produced by the specific project or facility that the bond financed✓
• b.Ad valorem property taxes levied by the issuer on the assessed value of local real estate
• c.The general fund appropriated each year by the state legislature in its annual budget
• d.Federal grants earmarked for the issuing municipality by a specific act of Congress

A revenue bond is self-supporting: it is repaid solely from the revenue (user fees, tolls, or charges) generated by the facility it financed, such as an airport, toll bridge, or utility. Because repayment depends on that project's success rather than broad taxing power, revenue bonds typically carry somewhat more credit risk than GO bonds.

Which agency mortgage security is backed by the full faith and credit of the U.S. government?

• a.Freddie Mac (FHLMC) participation certificates
• b.Ginnie Mae (GNMA) pass-throughs✓
• c.Fannie Mae (FNMA) pass-throughs
• d.Private-label mortgage bonds

Ginnie Mae (GNMA) is a government-owned corporation, and its pass-through securities carry the explicit full faith and credit guarantee of the U.S. government. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) whose securities are NOT directly backed by the U.S. government's full faith and credit.

Fannie Mae (FNMA) is best described as a:

• a.Private hedge fund that trades Treasury bonds for wealthy accredited investors
• b.Government-sponsored enterprise that buys mortgages and issues mortgage-backed securities✓
• c.Federal agency wholly owned by the U.S. Treasury and directly backed by its full faith and credit
• d.Municipal issuer whose tax-exempt housing bonds fund state and local agencies

Fannie Mae is a publicly traded government-sponsored enterprise (GSE) that purchases mortgages from lenders and packages them into mortgage-backed securities. Its securities are not directly guaranteed by the U.S. government, so they typically yield slightly more than Treasuries or Ginnie Maes to compensate for the modestly higher perceived risk.

Freddie Mac (FHLMC) primarily:

• a.Issues short-term Treasury bills on behalf of the federal government to fund the deficit
• b.Purchases mortgages and issues mortgage-backed securities to support the secondary mortgage market✓
• c.Sets the federal funds target rate at the Federal Open Market Committee's meetings
• d.Insures bank deposits up to the $250,000 FDIC limit at each insured institution

Freddie Mac is a government-sponsored enterprise that buys mortgages, mainly from thrift institutions, and pools them into mortgage-backed securities. Like Fannie Mae, it adds liquidity to the secondary mortgage market, and its securities are not directly backed by the U.S. government's full faith and credit.

Compared with U.S. Treasury securities, GSE agency securities such as FNMA debentures generally offer:

• a.A slightly higher yield to compensate for the absence of a direct full-faith-and-credit guarantee✓
• b.A complete exemption from federal income tax on all of the interest paid to investors
• c.Exactly the same yield, because both are treated as direct obligations of the U.S. Treasury
• d.A lower yield because their principal and interest payments are federally insured to the FDIC limit

GSE securities are not directly guaranteed by the U.S. government, so investors demand a slightly higher yield than on comparable Treasuries to compensate for the marginally higher credit risk. Both are still considered very high quality, but the yield spread reflects the difference in backing.

A collateralized mortgage obligation (CMO) is:

• a.A share of common stock issued by a mortgage banking company that originates residential home loans
• b.A Treasury security that pays a fixed semiannual coupon and carries the full faith and credit of the U.S. government
• c.A single municipal revenue bond secured by the real estate taxes levied within the issuing district
• d.A security backed by a pool of mortgages and divided into tranches with different maturities and risk levels✓

A CMO takes a pool of mortgages (or mortgage-backed securities) and redistributes the principal and interest into separate classes called tranches. Each tranche has a different expected maturity and exposure to prepayment risk, letting investors choose the cash-flow profile that fits their needs. CMOs are backed by mortgages, not by the direct full faith and credit of the U.S. government.

In a CMO, the different tranches primarily allow investors to:

• a.Select a class with a prepayment and maturity profile matching their goals✓
• b.Receive monthly mortgage interest that is exempt from federal income tax
• c.Convert the tranche into shares of the issuing agency's common stock
• d.Avoid interest rate risk entirely, because the tranches are Treasury-guaranteed

CMO tranches channel mortgage prepayments to different classes in a set order, so each tranche has a distinct average life and prepayment exposure. An investor wanting more predictable, shorter cash flows can choose an earlier tranche, while one seeking higher yield can accept a later, more prepayment-sensitive tranche. This structure tailors risk, but does not remove interest rate risk.

Treasury STRIPS are best described as:

• a.Short-term Treasury bills sold at face value that pay a fixed coupon every six months
• b.Municipal bonds that have had their federal tax exemption stripped away by the state or city that issued them
• c.Zero-coupon securities created by separating the interest and principal payments of Treasury notes and bonds✓
• d.Floating-rate agency notes whose coupon resets periodically against a short-term rate

STRIPS (Separate Trading of Registered Interest and Principal of Securities) are created when a Treasury security's coupon and principal payments are separated and sold individually as zero-coupon instruments. Each STRIP is bought at a discount and pays face value at maturity, with no periodic interest. They are backed by the U.S. government but carry phantom (imputed) taxable income each year.

U.S. Treasury bills (T-bills) are:

• a.Perpetual securities that have no stated maturity date and keep paying interest to the holder forever
• b.Short-term securities issued at a discount and maturing at face value, paying no periodic coupon✓
• c.Long-term bonds that pay semiannual coupons for as long as thirty years to maturity
• d.Tax-exempt municipal securities issued by state and local governments to fund projects

T-bills are short-term U.S. government obligations with maturities of one year or less. They pay no periodic interest; instead they are sold at a discount to face value, and the investor's return is the difference between the discounted purchase price and the face value received at maturity. They are considered virtually free of credit risk.

The main difference between a Treasury note and a Treasury bond is:

• a.Notes are exempt from federal income tax while bond interest is fully taxable
• b.Their maturity length, with notes maturing in 2 to 10 years and bonds in more than 10 years✓
• c.Notes are backed by the full faith and credit of the government while bonds are not
• d.Notes pay no interest and mature at par while bonds pay a semiannual coupon

Treasury notes and bonds both pay semiannual coupons and are backed by the U.S. government; the key difference is maturity. Notes are issued with maturities of 2 to 10 years, while bonds are issued with maturities greater than 10 years (up to 30 years). Both are subject to interest rate risk that increases with maturity.

Treasury Inflation-Protected Securities (TIPS) protect investors by:

• a.Paying a coupon that is reset each month to the federal funds rate
• b.Adjusting the bond's principal value with changes in the Consumer Price Index✓
• c.Converting into common stock whenever inflation exceeds a 5% threshold
• d.Guaranteeing a real return of at least 3% a year above the coupon

With TIPS, the principal is adjusted up or down based on changes in the Consumer Price Index (CPI). The fixed coupon rate is applied to this adjusted principal, so both interest payments and the final principal repayment rise with inflation. This makes TIPS a direct hedge against purchasing-power (inflation) risk.

A negotiable (jumbo) certificate of deposit differs from an ordinary bank CD mainly because it:

• a.Is fully insured by the FDIC up to $1 million per depositor
• b.Pays the holder no interest until it is redeemed at par
• c.Can be traded in the secondary market before maturity✓
• d.Is a Treasury obligation sold through Fed auctions

A negotiable CD is a large-denomination time deposit (typically $100,000 or more) that can be bought and sold in the secondary market, giving the holder liquidity before maturity. Ordinary retail CDs are non-negotiable and usually charge a penalty for early withdrawal. Amounts above the FDIC limit are not insured, so a negotiable CD carries some credit risk of the issuing bank.

Commercial paper is:

• a.Short-term unsecured corporate debt sold at a discount, typically maturing in 270 days or less✓
• b.Common stock issued by large commercial banks and distributed to investors through their branches
• c.A long-term secured revenue bond issued by a municipality and backed by its full taxing power
• d.A federally guaranteed mortgage security backed by Ginnie Mae pass-through pools of home loans

Commercial paper is a short-term, unsecured promissory note issued by corporations to fund short-term needs such as payroll or inventory. It is usually sold at a discount and matures in 270 days or less, which exempts it from full SEC registration. Because it is unsecured, only financially strong issuers can sell it, and it carries the credit risk of the issuer.

A banker's acceptance (BA) is a money-market instrument most commonly used to finance:

• a.International trade transactions✓
• b.Long-term corporate expansion
• c.Municipal school construction
• d.Long-term federal budget deficits

A banker's acceptance is a time draft that a bank has agreed (accepted) to pay at a future date, effectively guaranteeing payment. Because it substitutes the bank's credit for the buyer's, it is widely used to finance imports and exports where the parties may not know each other's creditworthiness. It trades at a discount in the money market like other short-term instruments.

A structured product is generally:

• a.A share of common stock issued by a finance company that specializes in securitizing mortgage and consumer loan pools
• b.A tax-exempt municipal revenue bond secured solely by the revenues of the specific project that it finances, such as a toll road or an airport terminal
• c.A security whose return is linked to the performance of an underlying asset, index, or basket, often combining a debt instrument with a derivative✓
• d.A plain U.S. government bond that pays a fixed semiannual coupon and returns its par value at maturity, with no derivative

Structured products are pre-packaged investments that typically combine a bond (for principal) with a derivative (for the payoff linked to an index, stock, or commodity). Their return depends on the performance of the reference asset, and they may carry issuer credit risk, complexity, and limited liquidity. They are not simple bonds or equities.

Systematic risk is best described as the risk that:

• a.Is diversified away once a portfolio holds 30 or more issuers
• b.Arises solely from a single bond issuer defaulting on its debt
• c.Affects the entire market and cannot be eliminated through diversification✓
• d.Applies only to a single company because of its own poor management

Systematic risk (also called market risk) affects the whole market or a broad segment of it, driven by factors such as recessions, interest rate changes, or geopolitical events. Because it moves all securities to some degree, it cannot be diversified away. Investors are compensated for bearing systematic risk through expected returns above the risk-free rate.

Unsystematic risk refers to risk that is:

• a.Caused only by rising interest rates across the bond and money markets
• b.Impossible to reduce by diversification, hedging, or any other technique
• c.Common to all securities in the market and driven by recessions and rate shifts
• d.Specific to a single company or industry and can be reduced through diversification✓

Unsystematic risk (also called specific or diversifiable risk) is unique to a particular company or industry, such as a product recall, a lawsuit, or a labor strike. Because these events are not correlated across all firms, holding a diversified mix of securities reduces or nearly eliminates unsystematic risk. What remains after full diversification is systematic (market) risk.

The primary purpose of diversifying a portfolio is to:

• a.Increase the portfolio's beta well above 1.0 so that it outperforms the market in every period
• b.Guarantee a positive return in every calendar year regardless of market conditions
• c.Reduce unsystematic risk by spreading investments across different securities and sectors✓
• d.Eliminate systematic (market) risk along with recession and interest-rate exposure

Diversification spreads money across different companies, industries, and asset classes so that a bad outcome in one holding does not devastate the whole portfolio. This reduces unsystematic (company-specific) risk. It cannot remove systematic risk, which affects the entire market, nor can it guarantee positive returns.

A stock with a beta of 1.5 is expected to:

• a.Move 1.5% for every 1% move in the overall market, making it more volatile than the market✓
• b.Pay a dividend yield 1.5 times the average yield of the overall market each year
• c.Move only half as much as the overall market, because any beta above 1.0 dampens price swings
• d.Be completely uncorrelated with the overall market, moving only on company-specific news

Beta measures a security's volatility relative to the overall market, which has a beta of 1.0. A beta of 1.5 means the stock tends to move 1.5% for each 1% move in the market, so it is more volatile and carries more systematic risk. A beta below 1.0 indicates lower volatility than the market.

Political risk is most relevant to an investor who:

• a.Purchases FDIC-insured bank certificates of deposit at a local branch
• b.Invests in securities of companies operating in countries with unstable governments✓
• c.Holds a broadly diversified portfolio of large U.S. blue-chip common stocks and bonds
• d.Buys short-term U.S. Treasury bills and rolls them over every 13 weeks

Political risk is the danger that a government's actions, such as expropriation, war, or sudden regulatory change, will hurt the value of investments in that country. It is especially significant for investments in emerging or unstable markets. Stable-government instruments such as U.S. Treasuries carry very little political risk.

Legislative (regulatory) risk refers to the possibility that:

• a.A change in law or regulation, such as tax rules, reduces an investment's value✓
• b.Rising market interest rates drive down the prices of outstanding bonds
• c.A foreign currency weakens against the dollar and erodes overseas returns
• d.A company's chief executive resigns and poor management destroys value

Legislative risk is the chance that new laws or regulatory changes will adversely affect an investment. For example, a change to the tax treatment of municipal bond interest could reduce demand and prices. It is distinct from interest rate risk, management risk, and currency risk.

Currency (exchange rate) risk is the risk that:

• a.A bond issuer will miss its scheduled interest payments or fail to repay principal at maturity, placing the issue in default
• b.Changes in exchange rates will reduce the value of a foreign investment when converted back to the investor's home currency✓
• c.A domestic company's earnings will fall because its own management makes poor operating decisions in its home market year after year
• d.Interest rates will rise sharply and push down the market price of outstanding fixed-rate bonds and of preferred shares already issued

Currency risk arises when an investor holds assets denominated in a foreign currency. If that currency weakens against the investor's home currency, the value of the investment falls when converted back, even if the asset performed well locally. This risk is central to international investing and is not present in purely domestic, home-currency holdings.

Liquidity risk is the risk that an investor:

• a.Will have the bond called away by the issuer well before its stated maturity
• b.Will earn less real income because inflation rises faster than the coupon
• c.Cannot sell an investment quickly at or near its fair market value✓
• d.Will lose principal because the issuer defaults on its scheduled payments

Liquidity (marketability) risk is the chance that an investor cannot convert an asset to cash quickly without accepting a significant price concession. Thinly traded securities, such as certain municipal bonds, limited partnerships, or small-cap stocks, carry higher liquidity risk. Highly traded assets like Treasury bills or large-cap stocks have low liquidity risk.

Reinvestment risk is greatest for an investor who:

• a.Buys a growth stock that pays no dividend at any point to its shareholders
• b.Holds a zero-coupon Treasury STRIP, whose accreted interest must be reinvested yearly
• c.Holds idle cash in a checking account that pays no stated interest rate
• d.Receives regular coupon payments during a period of falling interest rates✓

Reinvestment risk is the danger that interest or principal received will have to be reinvested at a lower rate than the original investment. It is greatest for coupon-paying bonds when rates are falling, because each coupon must be reinvested at the new lower rate. Zero-coupon bonds like STRIPS have no interim payments to reinvest, so they avoid reinvestment risk if held to maturity.

An investor holding a 20-year municipal bond faces the greatest interest rate risk because:

• a.Municipal bonds are tax-exempt, so their prices do not react to market interest rates
• b.The bond's coupon rate is variable and resets with each change in rates
• c.Municipal issuers can raise taxes at will, so rate moves are the only risk
• d.The longer the maturity, the more the bond's price falls when interest rates rise✓

Interest rate risk is the tendency of bond prices to fall as market rates rise, and it increases with the length of maturity. A 20-year bond's price is far more sensitive to a rate change than a 2-year bond's. This is a form of systematic risk that affects all fixed-rate bonds, tax-exempt or not.