Series 65 — Investment Adviser Law Study Guide (2026)

Introduction

Before you can recommend an investment, you have to understand the economic weather it lives in and the business that stands behind it. This chapter builds two toolkits. The first is macroeconomics — the business cycle, monetary and fiscal policy, interest rates, and the indicators that tell you where the economy is headed. The second is the quantitative toolkit every adviser uses: how to read a company's financial statements, how to measure return and risk, and how the time value of money turns a future dollar into a present one. None of it is advanced, but all of it recurs: the returns you compute here reappear in Chapter 3's portfolio math, and the interest-rate story here drives the bond pricing in Chapter 2.

The business cycle

The economy moves through four repeating phases, and the exam expects you to name them and their order: expansion, peak, contraction (recession), and trough, after which recovery begins a new expansion.

• Expansion — GDP rises, unemployment falls, corporate profits and consumer spending grow, and inflation tends to build.
• Peak — the top of the cycle, where growth stalls before turning down.
• Contraction / recession — output falls. The common rule of thumb is a recession = two consecutive quarters of declining real GDP. A severe, prolonged contraction is called a depression.
• Trough — the bottom, from which recovery begins.

Gross Domestic Product (GDP) is the total value of all final goods and services produced in a country in a period; it is the standard scorecard for the size and direction of the economy. "Real" GDP is adjusted for inflation.

Economic indicators

Indicators are classified by their timing relative to the economy — a favorite exam distinction.

• Leading indicators move before the economy turns: stock prices (S&P 500), building permits and new housing starts, new orders for durable goods, initial unemployment claims (inverted), and the money supply.
• Coincident indicators move with the economy: nonfarm payroll employment, industrial production, and personal income.
• Lagging indicators move after the economy has turned: the unemployment rate, corporate profits, the average duration of unemployment, and the prime rate.

Inflation is a general rise in prices that erodes purchasing power; it is commonly measured by the Consumer Price Index (CPI). Deflation is a general fall in prices. Mild inflation is normal in an expansion; stagflation — stagnant growth with high inflation — is the unusual, painful combination.

Monetary policy — the Federal Reserve

Monetary policy is run by the Federal Reserve (the Fed), the U.S. central bank, which manages the money supply to pursue stable prices and maximum sustainable employment. Its rate-setting arm is the Federal Open Market Committee (FOMC).

• Open market operations — the main tool. The Fed buys government securities from banks to add money to the system, pushing interest rates down (easing); it sells securities to drain money, pushing rates up (tightening).
• The discount rate is what the Fed charges banks that borrow directly from it. Lowering it signals easier credit.
• The reserve requirement is the fraction of deposits banks must hold rather than lend. Raising it tightens credit; lowering it eases.
• Easy vs. tight money. Easing lowers rates to spur borrowing, spending, and growth. Tightening raises rates to cool an overheating economy and fight inflation. Translate any policy move into "more money, lower rates" or "less money, higher rates."

Fiscal policy — Congress and the President

Fiscal policy is the government's use of taxing and spending to influence the economy, and it belongs to Congress and the President, not the Fed. Cutting taxes or increasing spending is expansionary; raising taxes or cutting spending is contractionary. A frequent exam trap swaps monetary and fiscal policy — keep them straight: the Fed = money; Congress = taxing and spending.

Two schools frame the debate: Keynesian economics stresses that government spending and demand management can smooth the cycle; monetarist (supply-side) economics stresses controlling the money supply and that markets self-correct.

Interest rates and the yield curve

Interest rates are the price of money, and several benchmark rates anchor the market.

• The federal funds rate is what banks charge each other for overnight loans of reserves — typically the most volatile short-term rate. The discount rate is what the Fed charges banks. The prime rate is what banks charge their most creditworthy corporate customers. The broker call (call money) rate is what banks charge broker-dealers on margin loans.
• The yield curve plots yield against maturity. A normal (positive) curve slopes upward — longer maturities pay more to compensate for time and risk. A flat curve shows little difference across maturities. An inverted curve, where short-term yields exceed long-term yields, is unusual and has historically often preceded recessions.

Currency and international factors

• Strong vs. weak dollar. A strong dollar buys more foreign currency — it makes imports cheaper for Americans but makes U.S. exports more expensive abroad. A weak dollar does the reverse and tends to help U.S. exporters.
• Balance of payments tracks money flows between a country and the rest of the world; the current account includes the trade balance (exports minus imports).
• Currency (exchange-rate) risk falls on an investor holding a foreign security: even if the security rises in its home price, an adverse exchange-rate move can erode the gain when converted back to dollars.

Reading the financial statements

An adviser analyzing a business works from three statements.

• The balance sheet is a snapshot at a point in time: Assets = Liabilities + Shareholders' Equity. Assets are what the company owns; liabilities are what it owes; equity (net worth / book value) is the difference.
• The income statement covers a period and reports revenue − expenses = net income (the "bottom line").
• The statement of cash flows reconciles net income to actual cash, split into operating, investing, and financing activities.

Key ratios the exam tests:

• Working capital = current assets − current liabilities — a dollar measure of short-term liquidity.
• Current ratio = current assets ÷ current liabilities — the same idea as a ratio.
• Quick ratio (acid test) = (current assets − inventory) ÷ current liabilities — a stricter liquidity test that removes inventory.
• Debt-to-equity = total debt ÷ shareholders' equity — a leverage (solvency) measure; higher means more borrowed money and more financial risk.
• Earnings per share (EPS) = (net income − preferred dividends) ÷ common shares outstanding.
• Price-to-earnings (P/E) = market price per share ÷ EPS — how much investors pay per dollar of earnings; a high P/E signals growth expectations.
• Dividend payout ratio = dividends per share ÷ EPS — the share of earnings paid out.

The time value of money and returns

Money available now is worth more than the same amount later, because it can be invested. That single idea powers most of the math on this exam.

• Future value (FV) compounds a present sum forward: FV = PV × (1 + r)ⁿ.
• Present value (PV) discounts a future sum back: PV = FV ÷ (1 + r)ⁿ. A higher discount rate lowers the present value.
• The rule of 72 estimates how long money takes to double: years ≈ 72 ÷ interest rate (%). At 8%, money doubles in about nine years.
• Net present value (NPV) is the present value of an investment's expected cash flows minus its cost; a positive NPV adds value. Internal rate of return (IRR) is the discount rate at which NPV equals zero — the investment's implied compound annual return.

Return measures — know the family:

• Current yield = annual income ÷ current market price. For a stock it uses the dividend; for a bond, the coupon.
• Holding period return = (ending value − beginning value + income) ÷ beginning value.
• Total return combines income and capital appreciation over a period.
• Real (inflation-adjusted) return ≈ nominal return − inflation rate. A 6% nominal return with 4% inflation is only about a 2% real return — the exam loves this subtraction.
• After-tax return subtracts the tax on income and gains; it matters most for high-bracket clients and taxable accounts.
• Risk-adjusted return relates return to the risk taken (the Sharpe ratio, Chapter 3).
• Expected return of a portfolio is the weighted average of the expected returns of its holdings.

Types of investment risk

Every recommendation trades return against risk, and the exam expects you to classify risk into two families.

Systematic risk affects the whole market and cannot be diversified away:

• Market risk — prices fall in a broad decline.
• Interest-rate risk — rising rates push bond (and rate-sensitive stock) prices down.
• Inflation (purchasing-power) risk — inflation erodes the real value of fixed payments; it is the chief risk of long-term bonds and cash.
• Reinvestment risk — falling rates force income to be reinvested at lower yields (the flip side of interest-rate risk).
• Currency risk — adverse exchange-rate moves on foreign holdings.

Unsystematic (diversifiable) risk affects a single company, industry, or sector and can be reduced by diversification:

• Business risk — a specific firm's operations disappoint.
• Financial / credit (default) risk — a specific issuer cannot pay interest or principal.
• Liquidity (marketability) risk — an asset cannot be sold quickly without a price concession.
• Legislative / regulatory and political risk — a law or political change hurts a specific holding.

The single most tested idea here: diversification reduces unsystematic risk but not systematic (market) risk. Adding more stocks cannot protect you from a market-wide crash.

Key facts — Chapter 1

• Business cycle order: expansion → peak → contraction → trough. Recession = two consecutive quarters of falling real GDP.
• Indicators: leading (stock prices, building permits, new orders) move first; coincident (payrolls, industrial production) move with; lagging (unemployment rate, corporate profits, prime rate) move after.
• Monetary policy = the Fed (open market operations = main tool; discount rate; reserve requirement). Fiscal policy = Congress + President (taxing and spending). Do not swap them.
• Fed buys securities → adds money → rates down (easing). Fed sells → drains money → rates up (tightening).
• Inverted yield curve (short-term yield > long-term yield) has historically preceded recessions; normal curve slopes up.
• Balance sheet: Assets = Liabilities + Equity. Income statement: Revenue − Expenses = Net Income.
• Working capital = CA − CL; current ratio = CA ÷ CL; quick ratio removes inventory; debt-to-equity = leverage.
• FV = PV(1+r)ⁿ; PV = FV ÷ (1+r)ⁿ; a higher discount rate lowers PV. Rule of 72: years to double ≈ 72 ÷ rate.
• Real return ≈ nominal return − inflation.
• Systematic risk (market, interest-rate, inflation, reinvestment, currency) cannot be diversified away; unsystematic risk (business, credit, liquidity, legislative) can. Diversification does not remove market risk.

Worked example 1 — real return

A client earns a 7% nominal return on a bond fund in a year when inflation, measured by the CPI, runs 4.5%. What is the approximate real return, and why does it matter?

Real return ≈ nominal return − inflation = 7% − 4.5% = about 2.5%. It matters because the client's purchasing power grew only ~2.5%, not 7%. This is exactly why inflation (purchasing-power) risk is the central danger of long-term fixed-income and cash: a "safe" 3% bond in a 4% inflation year delivers a negative real return, quietly shrinking what the money can buy.

Worked example 2 — systematic or unsystematic?

A client holds 40 different stocks and asks whether that protects her from a recession-driven market decline.

No. Spreading money across 40 stocks diversifies away unsystematic (company-specific) risk, but a recession-driven decline is systematic (market) risk, which hits the whole market at once. Diversification cannot remove it; only reducing market exposure (for example, holding assets with low correlation to stocks, or lowering the equity allocation) reduces systematic risk. Naming the risk type correctly is half the battle on this exam.

Exam traps — Chapter 1

• Monetary vs. fiscal. The Fed conducts monetary policy (money supply, open market operations); Congress and the President conduct fiscal policy (taxing and spending). Answer choices deliberately swap them.
• "Diversification reduces all risk." False — it reduces unsystematic risk only. Systematic (market) risk remains.
• Lagging vs. leading. The unemployment rate is a lagging indicator; stock prices and building permits are leading. Test-writers put a leading and a lagging indicator in the same question.
• Nominal vs. real return. If the question mentions inflation, subtract it — the "return" they want is usually the real return.
• Higher discount rate → lower present value (not higher). Discounting and compounding move in opposite directions.
• Inverted curve ≠ normal. An inverted curve (short rates above long rates) is the recession-warning shape; a normal curve slopes upward.