FINRA SIE — Securities Industry Essentials — All Questions

A firm's office of supervisory jurisdiction receives a complete and correct application package for a deferred variable annuity on Wednesday, March 4, 2026. Assume no holidays and that the firm waits as long as the rule permits. By what date must a registered principal review the transaction?

• a.Wednesday, March 11, 2026
• b.Thursday, March 12, 2026
• c.Friday, March 13, 2026✓
• d.Monday, March 16, 2026

Rule 2330 requires a principal to review the application before it is sent to the insurer and no later than seven business days after the office of supervisory jurisdiction receives a complete and correct package. Counting from March 4, the seven business days are March 5, 6, 9, 10, 11, 12 and 13, so the deadline is Friday, March 13. March 11 counts seven calendar days and so includes the weekend. March 12 stops at six business days. March 16 is the eighth business day and would be late.FINRA Rule 2330(c)

Who sets the minimum length of the free-look period during which a newly issued annuity contract can be cancelled for a refund?

• a.The insurer, which may offer any period it chooses, including none
• b.The SEC, which fixes one period for every annuity sold nationally
• c.FINRA, through the principal review timing in Rule 2330
• d.State insurance law, so the period varies from state to state✓

A free-look provision is a feature of the insurance contract, and the minimum length is set by state insurance law. FINRA notes that it typically ranges from 10 to 30 days depending on the state. The SEC does not fix a single national period. Rule 2330 governs principal review of recommendations, and its seven-business-day deadline has nothing to do with the buyer's right to cancel. An insurer cannot choose to offer none, because state law requires the provision.

A 40-year-old client wants to fund an IRA by buying a variable annuity inside it, mainly for the tax deferral. What should the representative make sure the client understands?

• a.Putting the annuity in an IRA gives the client two layers of tax deferral
• b.Tax deferral on the annuity ends at age 59½ unless it sits inside an IRA
• c.Earnings in an annuity held inside an IRA come out tax-free in retirement
• d.The IRA already defers tax, so the annuity adds no further tax benefit and its fees still apply✓

Earnings in an IRA already grow tax-deferred, so wrapping an annuity inside it adds no extra deferral. The client would still pay the annuity's mortality and expense, advisory and rider charges, which is why the decision has to rest on the annuity's other features, such as a death benefit or guaranteed income. The claim of two layers of deferral is the common misunderstanding. Annuity earnings inside a traditional IRA are taxed as ordinary income when withdrawn, and the age 59½ rule concerns an early-withdrawal penalty, not the end of deferral.FINRA Rule 2330(b)(1)

A client with a nonqualified annuity wants to exchange it without recognizing the gain. Under IRC Section 1035, which exchange qualifies?

• a.An annuity contract for shares of a mutual fund
• b.An annuity contract for a bank certificate of deposit
• c.An annuity contract for another annuity✓
• d.An annuity contract for a life insurance policy

Section 1035 lets an annuity contract be exchanged for another annuity contract, or for a qualified long-term care contract, with no gain or loss recognized. The rule runs in one direction: a life insurance contract can be exchanged for an annuity, but an annuity cannot be exchanged for a life insurance policy tax-free. Mutual fund shares and certificates of deposit are not insurance contracts, so moving into either one is a taxable surrender of the annuity.IRC Section 1035(a)(3)

A customer's annuity has a contract value of $80,000. The surrender charge is 7% in contract year 1 and drops one percentage point each year. The contract has no free-withdrawal provision. What is the surrender charge if the customer surrenders the entire contract during contract year 3?

• a.$4,000✓
• b.$3,200
• c.$4,800
• d.$5,600

The charge falls from 7% in year 1 to 6% in year 2 and 5% in year 3, and 5% of $80,000 is $4,000. With no free-withdrawal provision, the charge applies to the whole amount withdrawn. The $4,800 figure uses the year 2 rate and the $5,600 figure uses the year 1 rate, both of which lag the schedule by a year or two. The $3,200 figure uses the year 4 rate, which jumps ahead of the schedule.FINRA Rule 2330(b)(1)(B)

A representative recommends that a customer exchange her deferred variable annuity for a new one. Under Rule 2330, the review of the exchange must consider whether the customer has had another deferred variable annuity exchange within what preceding period?

• a.12 months
• b.24 months
• c.60 months
• d.36 months✓

Rule 2330 lists several factors the firm must weigh in an exchange: surrender charges on the old contract, a new surrender period, loss of existing benefits, increased fees, and whether the customer has had another deferred variable annuity exchange within the preceding 36 months. The 12-month and 24-month periods are shorter than the rule's look-back and would miss exchanges the rule counts, and the 60-month period is longer than the rule requires.FINRA Rule 2330(b)(1)(B)

After annuitizing a variable annuity, a retiree owns 240 annuity units. Last month the annuity unit value was $10.00 and this month it is $9.50. The accumulation unit value is $15.20. What is this month's payment?

• a.$2,400
• b.$3,648
• c.$2,340
• d.$2,280✓

Once the contract is annuitized, the payment equals the number of annuity units times the current annuity unit value: 240 x $9.50 = $2,280. The number of annuity units stays fixed and the unit value changes with performance relative to the assumed interest rate, so the payment is not locked at last month's $2,400. Averaging the two unit values to get $9.75 and a $2,340 payment has no basis. The $3,648 figure multiplies by the accumulation unit value, which applies only before annuitization.

A married 65-year-old man wants his annuity payments to continue for as long as either he or his wife is alive. Which payout option fits?

• a.Period certain of 20 years, which pays for a fixed term
• b.Life with 10 years certain, which pays at least ten years
• c.Life only, which pays until the annuitant's death
• d.Joint and last survivor, which pays until the second death✓

A joint and last survivor option keeps paying until both annuitants have died, so the wife is covered for her lifetime if she outlives him. A life-only option stops at his death and pays the largest monthly amount for that reason. Life with 10 years certain guarantees ten years of payments to a beneficiary but ends after that if the annuitant has died, so it does not cover the wife for life. A 20-year period certain pays for a fixed term whether or not either spouse is alive and ends even if both are still living.

A 529 account meets every condition for a rollover to the beneficiary's Roth IRA. Earlier rollovers from 529 accounts to this beneficiary's Roth IRA total $22,000. Ignoring the annual limit, what is the most that can still be rolled over?

• a.$35,000, because the cap applies separately to each 529 account
• b.$10,000, which is the lifetime cap for student loan repayment
• c.$13,000, the part of the $35,000 lifetime cap not yet used✓
• d.$22,000, matching the amount already rolled over

The tax code caps the total of these Roth rollovers at $35,000 for the beneficiary over all years and all 529 accounts combined, so $35,000 minus the $22,000 already moved leaves $13,000. The cap is not per account and does not reset. The $22,000 figure is simply the amount used. The $10,000 figure belongs to a different rule, the lifetime limit on 529 money used to repay student loans.IRC Section 529(c)(3)(E)

A parent opened a 529 account for a child 12 years ago, and every contribution is more than five years old. The parent asks a registered representative whether funds can be moved to the child's Roth IRA now. What is the correct answer?

• a.Yes, up to the annual Roth IRA limit, because all contributions are over five years old
• b.Not yet, because the account must be 15 years old✓
• c.Yes, but only the earnings, since contributions were already taxed
• d.Never, because a 529 account cannot be rolled into any Roth IRA

The Roth rollover rule has several conditions at once: the account must have been maintained for 15 years, the money moved must come from contributions (and their earnings) made more than five years earlier, the transfer must go directly to the beneficiary's Roth IRA, and annual and lifetime caps apply. Meeting the five-year test does not satisfy the 15-year test, and at 12 years the account is three years short. The rollover is not limited to earnings, and it is allowed once the conditions are met, so it is not prohibited outright.IRC Section 529(c)(3)(E)

For 2026 the annual gift tax exclusion is $19,000 per donor for each recipient. A grandmother who has made no other gifts to a grandchild makes the five-year election for a single 529 contribution. What is the largest contribution that can be covered by the exclusions in the election?

• a.$95,000, which is five times the annual exclusion✓
• b.$114,000, because the election covers the current year plus five more years
• c.$76,000, because the current year is excluded from the election
• d.$19,000, because the exclusion cannot be accelerated

The election lets a donor treat a large 529 contribution as if it were made in equal parts over five years, so the contribution can be as much as five times the annual exclusion: 5 x $19,000 = $95,000. Limiting it to one year's exclusion ignores the election. The current year is one of the five years, not an extra year, so the multiplier is five rather than four or six.IRC Section 529(c)(2)(B)

A 529 account is worth $50,000, made up of $30,000 of contributions and $20,000 of earnings. The owner takes a $10,000 withdrawal that is not for a qualified expense, and no exception applies. What is the 10% additional tax on this withdrawal?

• a.$400, because 40% of the withdrawal is earnings✓
• b.$1,000, because the tax applies to the whole withdrawal
• c.$2,000, because the tax applies to all the earnings in the account
• d.$4,000, because the earnings portion is the amount of the additional tax

A non-qualified withdrawal is split between contributions and earnings in the same proportion as the account: earnings are $20,000 of $50,000, or 40%, so $4,000 of this withdrawal is earnings. The earnings are taxed as ordinary income and the additional tax is 10% of that amount, or $400. Contributions come back tax-free and are outside the penalty. Applying the percentage to the whole withdrawal, or to all earnings in the account, overstates the tax. The $4,000 is the taxable earnings, not the additional tax.IRC Section 529(c)(3)(A) and (c)(6)

A 529 plan distribution used to repay a beneficiary's qualified education loans has a $10,000 lifetime limit for that individual. The beneficiary has already used $6,000 of it on her own loans. What is the most that can still be treated as a qualified expense for her own loans?

• a.$4,000, the unused part of the lifetime limit✓
• b.$10,000, because the limit applies to each loan separately
• c.$6,000, matching the amount already used
• d.$16,000, which adds the used amount to the limit

The limit is a lifetime total for each individual, not a per-loan or yearly amount, so $10,000 less the $6,000 already used leaves $4,000. Treating it as a fresh $10,000 for each loan ignores that it is cumulative. The $6,000 figure is what has been used. Adding the used amount to the limit gets the arithmetic backward, since using the limit reduces what remains.IRC Section 529(c)(9)(B)

An account owner changed a 529 account's investment option in March and again in July of the same year. In October the owner wants to move to a more conservative option in the same plan, with no change of beneficiary and no rollover. What is the result under the federal rule?

• a.Not allowed until the next calendar year, because only two changes per calendar year are permitted✓
• b.Allowed, but only into a money market or stable value option
• c.Allowed, because changes are restricted only if made within 90 days of each other
• d.Allowed, because federal law permits one change each quarter

Federal law lets a 529 plan owner redirect the investment of existing contributions no more than twice in a calendar year, apart from a change of beneficiary or a rollover. March and July used both changes, so an October change must wait for the next calendar year. Federal law has no quarterly allowance, no 90-day spacing rule, and no exception for a particular kind of option.IRC Section 529(b)(4)

A 38-year-old receives Social Security Disability Insurance benefits. The disability began when she was 30. She asks a registered representative whether she can open an ABLE account. What is the correct response?

• a.No, because the disability must have begun before age 26
• b.Yes, because her disability began before age 46 and she receives Social Security disability benefits✓
• c.No, because only recipients of Supplemental Security Income qualify
• d.No, because an ABLE account can be opened only for a person under 18

An individual is eligible if entitled to Social Security benefits based on blindness or disability under title II (SSDI) or title XVI (SSI) and the condition began before age 46. The age-26 cutoff was the earlier rule and no longer applies. Eligibility is not limited to SSI recipients, and there is no under-18 requirement. A disability certification filed with the Treasury is a separate route for people who do not receive those benefits.IRC Section 529A(e)(1)

The designated beneficiary of an ABLE account has died. The account still holds money after all outstanding qualified disability expenses are paid. What may a state do?

• a.File a claim against the remaining balance to recover Medicaid costs paid after the account was opened✓
• b.Claim only the earnings, because contributions belong to the original contributors
• c.Take the entire balance, whatever the amount of Medicaid assistance provided
• d.Nothing, because ABLE account assets pass only to heirs and are protected from state claims

An ABLE account has a Medicaid payback rule: after the beneficiary's death, and after outstanding qualified disability expenses, a state can file a claim for the remaining balance up to the total medical assistance paid for the beneficiary since the account was established, net of certain premiums. The account is therefore not shielded from every state claim. The state's claim is limited to the Medicaid paid, not the whole balance. It reaches contributions as well as earnings, so it does not stop at earnings.IRC Section 529A(f)

An investor holds a limited partnership interest in a direct participation program and has $18,000 of suspended passive losses from it. The investor sells the entire interest to an unrelated buyer in a fully taxable transaction. What happens to the suspended losses?

• a.They transfer to the buyer along with the partnership interest
• b.They stay suspended until the investor has passive income from another partnership
• c.They are released and can be deducted against any kind of income in the year of sale✓
• d.They are limited to $3,000 a year, like net capital losses

When a taxpayer disposes of the entire interest in a passive activity in a fully taxable transaction with an unrelated party, the loss is no longer treated as passive, so the suspended amounts can offset other income, including wages and portfolio income. Staying suspended is the result when a passive activity is kept, not sold. The $3,000 cap belongs to the capital loss rules, which do not govern passive losses. The losses stay with the seller and do not move to the buyer.IRC Section 469(g)(1)

A limited partner owns 10% of a direct participation program. The partnership has $100,000 of net income for the year and distributes $4,000 in cash to this investor. How much income does the investor report from the partnership on the year's Schedule K-1?

• a.$10,000, the investor's share of income✓
• b.$4,000, since income is taxed only when cash is received
• c.$0, because the partnership itself pays the tax
• d.$100,000, because the partnership reports all of its income to every partner

A partnership is a pass-through entity that pays no income tax. Each partner reports a share of its income whether or not cash is distributed, so the investor reports 10% of $100,000, or $10,000. Income is not taxed only when distributed, which means the $4,000 cash is not the measure. Because the tax falls on the partners, saying the partnership itself pays is wrong. Each partner reports only the share allocated to him or her, not the total.IRC Sections 701 and 702(a)

An investor buys a working interest in an oil and gas drilling program as a general partner, holding it through an entity that does not limit the investor's liability. The investor spends little time on the program. How are the program's losses treated for passive loss purposes?

• a.As passive, because every partnership interest is a passive activity
• b.As nonpassive, so they can offset the investor's active income✓
• c.As passive, because the investor does not materially participate
• d.As nonpassive only if the investor works at least 500 hours during the year

The tax code excludes from the definition of passive activity any working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the taxpayer's liability. Material participation is therefore not the test, so the investor's few hours do not turn the loss passive. Not every partnership interest is passive, because the working interest rule is a stated exception. The 500-hour test is a material participation test and does not apply here.IRC Section 469(c)(3)

In year 1, an investor has $25,000 of passive losses from a direct participation program and no passive income, so the losses are disallowed and carried forward. In year 2, the investor has $40,000 of passive income from another investment and a new $10,000 passive loss. What is the investor's net passive income in year 2 after using the carried-forward losses?

• a.$40,000, because the carried-forward losses expire after one year
• b.$15,000, because the new $10,000 loss is ignored
• c.$30,000, because carried-forward losses are not used until the program is sold
• d.$5,000✓

Passive losses that are not allowed in one year carry forward and offset passive income in later years. Year 2 passive income is $40,000, reduced by the new $10,000 loss and by the $25,000 carryforward: 40,000 - 10,000 - 25,000 = $5,000. Waiting for a sale gives $30,000, which skips the carryforward. Leaving out the new loss gives $15,000. A one-year expiration gives $40,000, but disallowed passive losses carry forward indefinitely.IRC Section 469(a) and (b)

A corporation owns income-producing real estate and has 85 shareholders. It meets every other REIT requirement and plans to distribute the required income. Can it qualify as a real estate investment trust?

• a.No, because beneficial ownership must be held by at least 100 persons✓
• b.Yes, because it distributes at least 90% of its taxable income
• c.Yes, because a REIT needs only 35 shareholders
• d.No, because only exchange-listed companies can qualify as REITs

To qualify as a REIT the beneficial ownership must be held by 100 or more persons for at least 335 days of a 12-month tax year. With 85 shareholders the company fails that test even if every other condition is met. The figure of 35 comes from private offering rules and has no role here. Distributing at least 90% is a separate requirement that does not replace the 100-owner test. Listing is not required, and non-traded REITs exist.IRC Section 856(a)(5)

A REIT has $400 million in total assets at the end of a quarter. At least 75% of the value of its total assets must be in real estate assets, cash and cash items, and government securities. What is the minimum value of those assets?

• a.$200 million
• b.$380 million
• c.$300 million✓
• d.$360 million

At the close of each quarter, at least 75% of the value of a REIT's total assets must be represented by real estate assets, cash and cash items, and government securities. 75% of $400 million is $300 million. The $380 million figure applies 95%, which is the gross income test. The $200 million figure applies 50%, and the $360 million figure applies 90%, which is the distribution requirement. Neither of those is the asset test.IRC Section 856(c)(4)(A)

A REIT has $50 million of gross income for the year. At least 95% of gross income must come from sources such as dividends, interest and rents from real property. What is the minimum amount that must come from those sources?

• a.$37.5 million
• b.$50 million
• c.$45 million
• d.$47.5 million✓

The REIT income test requires at least 95% of gross income to be derived from specified sources including dividends, interest, rents from real property, and gain from sales of real property and securities. 95% of $50 million is $47.5 million. The $37.5 million figure applies 75%, which is a separate test for real property related income. The $45 million figure applies 90%. Requiring all $50 million overstates the test, since up to 5% may come from other sources.IRC Section 856(c)(2)

A private fund that is not a venture capital fund wants to sell interests to 140 investors, every one of them a qualified purchaser, with no public offering and without registering as an investment company. Which exclusion permits this?

• a.Section 3(c)(1), because accredited investors do not count toward its owner limit
• b.Section 3(c)(1), which allows up to 250 investors
• c.Section 3(c)(7), which allows ownership by qualified purchasers only and sets no fixed cap on the number of owners✓
• d.None; a fund with more than 100 investors must register as a mutual fund

Section 3(c)(7) excludes an issuer whose securities are owned only by qualified purchasers and that makes no public offering, and the Act sets no fixed number of owners for it. Section 3(c)(1) is limited to 100 beneficial owners, and the 250 figure applies only to a qualifying venture capital fund, which this fund is not. Accredited investors are counted under 3(c)(1), so being accredited does not exempt anyone from the count. A fund over 100 investors is not forced to register, since 3(c)(7) is a second route.Investment Company Act Sections 3(c)(1) and 3(c)(7)

Which of the following individuals is a qualified purchaser under the Investment Company Act?

• a.A person with income above $200,000 in each of the last two years
• b.A person with a $1 million net worth, not counting a primary residence
• c.A person with $5 million of net worth, most of it the value of a primary residence
• d.A person who owns at least $5 million in investments✓

An individual qualified purchaser is a natural person who owns at least $5 million in investments. The test counts investments, not total net worth, so a large home does not help. The $1 million net worth test (excluding the home) and the $200,000 income test are ways to be an accredited investor, which is a lower standard under the Securities Act and does not make someone a qualified purchaser.Investment Company Act Section 2(a)(51)

A hedge fund charges a 2% management fee on its $50 million of year-end net assets and a 20% incentive fee on the gain remaining after the management fee. The fund earned a gross gain of $8 million before any fees. No hurdle rate or high-water mark applies. What are the total fees?

• a.$1.6 million
• b.$1.4 million
• c.$2.4 million✓
• d.$2.6 million

The management fee is 2% of $50 million, or $1.0 million. The incentive fee is 20% of the gain left after that fee: 20% x ($8.0 million - $1.0 million) = $1.4 million. Total fees are $1.0 million + $1.4 million = $2.4 million. Charging the incentive fee on the full $8 million gives $1.6 million and a total of $2.6 million. The $1.4 million answer leaves out the management fee, and $1.6 million is the incentive fee on the gross gain alone.

An ETF share trades at $50.00 on the exchange while the net asset value per share is $48.00. To the nearest hundredth of a percent, what is the premium to NAV?

• a.2.00%
• b.4.00%
• c.104.17%
• d.4.17%✓

The premium is measured against NAV: ($50.00 - $48.00) / $48.00 = 4.17%. Dividing the $2.00 difference by the $50.00 market price gives 4.00%, which uses the wrong base. Stating the $2.00 dollar difference as a percent gives 2.00% and ignores the base entirely. The figure of 104.17% is the price as a percentage of NAV, not the premium.

An ETF's shares trade well above the value of its underlying holdings. Which action by an authorized participant tends to push the ETF's price back toward its NAV?

• a.Sell ETF shares directly back to the fund for cash at the market price
• b.Deliver the underlying basket of securities to the fund for new ETF shares, then sell those shares in the market✓
• c.Redeem ETF shares with the fund for the underlying basket, then sell the securities in the market
• d.Buy ETF shares in the market and hold them to support the price

When an ETF trades at a premium, an authorized participant can profit by assembling the underlying securities, delivering them to the fund for newly created ETF shares, and selling those shares at the higher market price. The added supply pushes the ETF price down toward NAV. Redeeming shares for the basket is the opposite trade and is used when shares trade at a discount. Buying more shares adds demand and widens the premium. Redemptions are priced at NAV through the creation and redemption process, not at the market price.

A fund holds $100 in a 2x daily leveraged ETF that seeks twice the daily return of an index. The index falls 10% on day 1 and rises 10% on day 2. Ignoring fees, what is the position worth after day 2?

• a.$99.00
• b.$100.00
• c.$98.00
• d.$96.00✓

A leveraged ETF resets daily. On day 1 it falls 20% to $80. On day 2 it rises 20%, which is $16, so it ends at $96. The index itself went from 100 to 90 to 99, a loss of 1%, so doubling that two-day return would suggest $98, but the fund does not track the two-day return. The $99 figure is the index result, and $100 assumes the gains and losses offset. Compounding of daily resets makes the result path-dependent.

An investor holds $10,000 in an inverse 2x daily ETF that seeks twice the opposite of an index's daily return. The index rises 3% in one day. Ignoring fees, what is the position worth at the close?

• a.$9,700
• b.$10,300
• c.$10,600
• d.$9,400✓

An inverse 2x ETF seeks -2 times the index return, so a 3% index gain means a 6% loss: $10,000 x 0.94 = $9,400. A $9,700 result would come from a 1x inverse fund. The $10,300 and $10,600 results have the direction wrong, as they treat the fund as if it gained when the index rose.

A U.S. investor owns a bond worth 10,000 euros. The bond's price in euros does not change, but the euro falls from $1.10 to $1.02. What is the investor's loss in dollars?

• a.$800✓
• b.$880
• c.$80
• d.$10,200

At $1.10 per euro the holding was worth $11,000. At $1.02 it is worth $10,200. The loss is $11,000 - $10,200 = $800, which is currency (exchange rate) risk even though the bond's price in euros was unchanged. The $880 figure takes 8 cents as 8% of the starting value, the $80 figure applies 8 cents once instead of to 10,000 euros, and $10,200 is the ending value, not the loss.

A certificate of deposit pays 4.5% a year while inflation runs at 3.1%. Using the simple approximation of nominal rate minus inflation, what is the investor's real return?

• a.4.5%
• b.-1.4%
• c.1.4%✓
• d.7.6%

The real return is the nominal return less inflation: 4.5% - 3.1% = 1.4%, the approximate gain in purchasing power. Adding the two figures gives 7.6%, which is not a purchasing power measure. The 4.5% figure is the nominal return, which ignores inflation. A result of -1.4% reverses the subtraction. This is purchasing power (inflation) risk: the nominal rate says nothing about what the money can buy.

An investor owns a mortgage pass-through security. Interest rates rise sharply and homeowners stop refinancing, so principal comes back more slowly than expected while the security's coupon is now below market rates. Which risk is the investor mainly experiencing?

• a.Reinvestment risk, because large cash flows must be put to work at lower rates
• b.Call risk, because the issuer is redeeming the security before maturity
• c.Extension risk, because the security's average life lengthens as prepayments slow✓
• d.Contraction risk, because principal is being returned early

Extension risk is the lengthening of a mortgage-backed security's average life when higher rates slow prepayments, leaving the investor holding a below-market coupon for longer. Contraction risk is the opposite, when falling rates speed prepayments and principal returns early. Principal is returning more slowly here, so there is no early redemption and no call. Reinvestment risk arises when cash comes back faster than expected and must be reinvested at lower rates, which is the opposite of this case.

An investor in a direct participation program needs cash after two years. There is no secondary market, and the only offer to buy her interest is at a deep discount to its value. Which risk has the investor run into?

• a.Purchasing power risk, because inflation has reduced the value of the proceeds
• b.Liquidity risk, because the interest cannot be sold quickly without a large price concession✓
• c.Interest rate risk, because rising rates have lowered the interest's price
• d.Credit risk, because the sponsor has failed to make a payment

Liquidity risk is the risk that an investment cannot be converted to cash quickly at a fair price. Direct participation program interests have no active market, so a seller who needs cash early may have to accept a steep discount. Nothing in the facts suggests the sponsor has defaulted, so credit risk is not the issue. The problem is not a rate move or inflation, which would affect the value of the interest rather than the ability to sell it.

Two competing manufacturers see sales fall by the same 15%. One is financed largely with debt, cannot cover its interest payments, and has its bonds downgraded. The other has no debt and stays profitable. Which risk explains the difference?

• a.Business risk, because the two firms operate in the same industry
• b.Market risk, because the sales decline reflects a market-wide fall in prices
• c.Financial risk, from the fixed interest obligations that come with borrowing✓
• d.Liquidity risk, because the bonds could not be sold at a fair price

Financial risk is the added risk of failing to meet fixed obligations that comes from financing with debt. Both firms faced the same business conditions, but the leveraged firm's fixed interest costs turned the same sales decline into a crisis. Business risk, which comes from the industry and operations, was identical for both and cannot explain the difference. Market risk is a broad price-level movement that would affect both alike. The difference arises from how each firm is financed, not from how easily the bonds trade.

Prices of tax-exempt municipal bonds fall while Congress debates eliminating the federal income tax exemption on their interest. Which risk is affecting bondholders?

• a.Credit risk, because the municipalities may be unable to pay interest
• b.Call risk, because the issuers may redeem the bonds early
• c.Interest rate risk, because market yields on all bonds have risen
• d.Legislative risk, because a change in law could reduce the value of the investment✓

Legislative risk is the chance that a change in law or regulation, here a change in tax treatment, will hurt the value of an investment. The bonds' tax exemption is a large part of their appeal, so the proposal alone can lower prices. Nothing indicates that the issuers' ability to pay has changed, so credit risk does not fit. Nothing suggests early redemptions. The price move comes from the policy debate, not from a general rise in market yields.

An investor puts $500 a month into a mutual fund for three months, when the price per share is $10, $8 and $5. What is the investor's average cost per share, to the nearest cent?

• a.$7.67
• b.$5.00
• c.$7.06✓
• d.$7.50

The investor buys 50 shares at $10, 62.5 shares at $8 and 100 shares at $5, for 212.5 shares and $1,500 invested. Average cost is $1,500 / 212.5 = $7.06. The $7.67 figure is the simple average of the three prices, which ignores that more shares are bought when the price is low. $7.50 is the midpoint of the high and low, and $5.00 is only the last price paid.

A $200,000 portfolio has a 60% stock and 40% bond target. After a rally, the stocks are worth $140,000 and the bonds $60,000. How much stock must be sold, with the proceeds going to bonds, to restore the target allocation?

• a.$80,000
• b.$10,000
• c.$20,000✓
• d.$28,000

At a 60% target, stocks should be worth 0.60 x $200,000 = $120,000. They are worth $140,000, so $20,000 of stock is sold and the proceeds buy bonds, bringing the bonds to $80,000, or 40%. Selling $10,000 only moves halfway. The $28,000 figure takes 20% of the stock value instead of the dollar gap to the target. Selling $80,000 would leave stocks at $60,000, matching the bonds, which is a 30% stock allocation.

An investor buys equal amounts of bonds maturing in 2, 4, 6, 8 and 10 years, and reinvests each maturing bond in a new 10-year bond. What is the main benefit of this laddered strategy?

• a.The investor earns the highest long-term yield on every dollar from the start
• b.The investor can time the market by selling the rungs that have risen in price
• c.Holdings are spread across several issuers, which lowers default risk
• d.Maturities are staggered, so only part of the portfolio is reinvested at any one set of interest rates✓

A ladder spreads maturities evenly, so cash returns at regular intervals and only a portion is reinvested at the then-current rates. That reduces the impact of rate changes on the whole portfolio. A ladder describes maturity dates, not issuers, so it does not diversify credit risk. Holding short maturities means that not every dollar earns the longest-term yield. A ladder is a steady approach, not an active strategy of selling bonds on price swings.

A client must pay a $50,000 tuition bill in 14 months and cannot accept a loss of principal. Which investment best matches the time horizon and the need to preserve principal?

• a.A high-yield bond fund, to earn more income before the bill is due
• b.A 30-year Treasury bond, to lock in a high yield
• c.A short-term U.S. Treasury security or a government money market fund✓
• d.A diversified stock index fund, to give the money time to grow

The goal is to have a known amount in 14 months, so the investment should be short-term and very low in credit risk and price volatility. Short-term Treasury securities and government money market funds fit both. A stock index fund can fall sharply within 14 months. A 30-year bond has a long maturity, so its price could drop if rates rise before the bill is due. A high-yield bond fund takes credit risk and price swings that the client has said cannot be tolerated.

A retiree wants a Treasury holding whose principal rises when the Consumer Price Index rises, so that the investment keeps pace with inflation. Which security matches that need?

• a.A Treasury STRIP, which pays a fixed amount at maturity
• b.A Treasury Inflation-Protected Security (TIPS), whose principal adjusts with changes in the CPI✓
• c.A 30-year Treasury bond, which pays a fixed coupon
• d.A Treasury bill, which is sold at a discount and matures within a year

TIPS principal is adjusted for changes in the Consumer Price Index, and the fixed interest rate is paid on the adjusted principal, so both the principal and the interest payments follow inflation. A STRIP is a zero-coupon security with a fixed face amount at maturity. A Treasury bond pays the same coupon on the same principal throughout its life. A Treasury bill is a short-term discount instrument with a fixed face value.

An investor's portfolio is concentrated in one stock. Which candidate offers the greatest diversification benefit, judged by its correlation with the stock already held?

• a.A correlation of -0.8✓
• b.A correlation of 0.0
• c.A correlation of +1.0
• d.A correlation of +0.5

The lower the correlation between assets, the more their price movements offset one another and the more risk is reduced. A correlation of -0.8 means the asset tends to move opposite to the existing stock, which gives the largest reduction in portfolio volatility. A correlation of +1.0 means the two move in lockstep, so there is no benefit. A correlation of +0.5 gives some benefit and 0.0 gives more, but neither is as strong as a negative correlation.

A taxable money market fund has 22% of its total assets in daily liquid assets and 55% in weekly liquid assets. Under Rule 2a-7, what may it do?

• a.It may not buy anything other than a daily liquid asset until it has at least 25% in daily liquid assets✓
• b.It may buy any security, because the weekly liquid asset minimum of 30% is the only test that applies to the fund
• c.It may not buy anything at all until it has at least 50% in daily liquid assets again
• d.It may buy any security at all, because 22% daily liquid assets is above the 10% minimum

Rule 2a-7 prohibits a fund from acquiring a security other than a daily liquid asset if, afterward, it would hold less than 25% of total assets in daily liquid assets (tax-exempt funds are excepted). It likewise requires at least 50% in weekly liquid assets. The fund here meets the weekly test but falls short on the daily one.17 CFR 270.2a-7(d)(4)(ii)-(iii)

An equity-indexed annuity typically promises a minimum guaranteed value of what portion of the premium paid, at a low guaranteed interest rate?

• a.100% of the premium at the index return, never less than zero
• b.50% of the premium at 5 to 7 percent interest
• c.At least 87.5% of the premium at 1 to 3 percent interest✓
• d.No minimum, because the return is tied only to the index

FINRA notes that equity-indexed annuities generally offer a guaranteed minimum interest rate, typically on at least 87.5% of the premium paid at 1 to 3 percent, plus an additional rate tied to a market index. The principal is guaranteed, but the market-linked interest is not.FINRA investor education: Annuities (indexed)

A client wants to buy a nonqualified annuity with after-tax savings. Which statement is correct?

• a.She can deduct up to $7,500 a year, like an IRA, since the contribution lowers her taxable income
• b.She cannot deduct the contribution, but there is no annual contribution limit on the annuity itself✓
• c.She is limited to the 401(k) deferral limit, because every annuity contribution counts toward that cap
• d.She can deduct the contribution only if she annuitizes within one year

Investments in nonqualified annuities are made with after-tax dollars, so the contributions are not deductible. Unlike IRAs and 401(k) plans, annuities don't have annual contribution limits, although an annuity held in a qualified plan is subject to that plan's limits.FINRA investor education: Annuities (taxes)

A retail investor sells a gold coin collection, held for four years, at a net gain. What is the maximum federal rate on that net long-term capital gain, according to the IRS?

• a.15%
• b.28%✓
• c.20%
• d.The investor's ordinary income rate, with no cap

The IRS states that net capital gains from selling collectibles such as coins or art are taxed at a maximum 28% rate. Most other long-term gains are taxed at lower rates of 0%, 15% or 20%.IRS Topic 409

A mutual fund has adopted a Rule 12b-1 plan with an asset-based sales charge and also pays service fees. What limits its total front-end, deferred and asset-based sales charges under FINRA Rule 2341?

• a.8.5% of total new gross sales
• b.3% of total new gross sales
• c.No cap, because shareholders approved the plan
• d.6.25% of total new gross sales plus interest charges, with a 6.25% cap on any one transaction✓

For funds with an asset-based sales charge that pay service fees, Rule 2341 caps the aggregate of those charges at 6.25% of total new gross sales plus interest at the prime rate plus 1%. Any single front-end or deferred charge cannot exceed 6.25% of the amount invested.FINRA Rule 2341(d)(2)(A)

A company issues convertible securities whose conversion price floats with the market, so a falling stock price means more shares are issued at conversion. What is the principal risk for existing shareholders?

• a.Dilution that can deepen as the price falls, sometimes called a death spiral✓
• b.Loss of voting rights for all common stockholders as soon as the first conversion takes place
• c.Mandatory conversion of the existing common stock into debt owed to the new lenders of the company
• d.A guaranteed increase in earnings per share, because the company has more shares to spread costs over

With a market-price-based conversion formula, lower prices mean more shares are issued, which dilutes existing holders and can push the stock price down further. Such deals are colloquially called floorless, toxic, death spiral or ratchet convertibles. A fixed conversion price is the conventional structure.SEC Investor.gov, Convertible Securities

On June 10 an investor sells 200 shares of ABC at a loss. On June 25 she buys call options on ABC. How does the wash sale rule treat the loss?

• a.The loss is disallowed, because acquiring an option to buy substantially identical stock within 30 days counts as a repurchase✓
• b.The loss is allowed, because options are not stock
• c.The loss is allowed, because the options were bought after 10 days
• d.The loss is disallowed only if she exercises the options within 30 days

The wash sale rule disallows a loss when, in the period beginning 30 days before and ending 30 days after the sale, the taxpayer acquires, or enters into a contract or option to acquire, substantially identical stock or securities. Buying call options on the same stock within that window triggers it.IRC 1091(a)

Which approval does Rule 12b-1 require before an open-end fund may pay distribution expenses from fund assets under a plan?

• a.Approval by a simple majority of the fund's transfer agents
• b.Approval by the fund's investment adviser alone
• c.Approval by the full board and by the directors who are not interested persons, voted in person at a meeting called for that purpose✓
• d.Approval by the SEC staff after a public comment period

A Rule 12b-1 plan must be approved by the board of directors and also by the directors who are not interested persons and have no financial interest in the plan, cast in person at a meeting called for the purpose. The plan continues beyond one year only if approved at least annually, and the board must review written reports of expenditures at least quarterly.17 CFR 270.12b-1(b)