NASAA Series 65 — All Questions

Fund X reports 15% portfolio turnover and Fund Y reports 140%. Which statement about a taxable investor comparing them is accurate?

• a.Fund Y's expense ratio already includes its brokerage commissions and spreads, so the two funds' costs can be compared directly
• b.Fund Y probably incurs trading costs not shown in its expense ratio and may distribute more short-term gains✓
• c.Fund Y's high turnover means it holds securities longer and defers more tax, so it is the more tax-efficient fund
• d.Fund X's 15% turnover means about 15% of its shareholders redeemed during the year, forcing it to sell holdings

Turnover measures how much of the portfolio was traded during the year. Brokerage commissions and other trading costs are not part of the expense ratio, and heavy trading tends to realize short-term gains that are passed through to taxable holders. Turnover has nothing to do with shareholder redemptions. High turnover means shorter holding periods, the reverse of deferring tax.Investment Company Act of 1940 s.30; Form N-1A

An investor puts $40,000 into each of two funds. Both earn 7% before expenses for the year. Fund A's expense ratio is 0.35% and Fund B's is 1.15%. Ignoring loads and taxes, by how much does Fund B's ending value trail Fund A's?

• a.$460
• b.$140
• c.$320✓
• d.$22.40

Net returns are 7.00% - 0.35% = 6.65% for Fund A and 7.00% - 1.15% = 5.85% for Fund B. On $40,000 the ending values are $42,660 and $42,340, a gap of $320, which is also 0.80% x $40,000. $460 is Fund B's entire expense charge, and $140 is Fund A's. $22.40 applies the 0.80-point gap to the $2,800 gain instead of to the assets.Form N-1A (fee table)

Why do ETFs generally pass through fewer capital gains than comparable open-end index mutual funds?

• a.Investors redeem directly with the fund for cash at NAV, so the fund never needs to sell securities to meet redemptions
• b.Exchange trading makes ETFs exempt from the rule requiring regulated funds to distribute their realized capital gains
• c.Trading on an exchange means the fund pays no portfolio transaction costs, so it realizes fewer taxable gains each year
• d.Authorized participants redeem in kind, so the ETF can hand over low-basis securities instead of selling them✓

When an authorized participant redeems a large block, the ETF usually delivers a basket of securities rather than cash, and handing over low-basis shares does not trigger a taxable sale inside the fund. Ordinary investors do not redeem with the fund; they sell on the exchange to other investors. ETFs are regulated investment companies and remain subject to the distribution rules. Exchange trading of the ETF's own shares has no effect on the fund's portfolio costs.Investment Company Act Rule 6c-11; IRC s.852

An equity ETF's shares trade at $50.40 while the net asset value of its underlying basket is $50.00. Which action by an authorized participant tends to close the gap?

• a.Selling the underlying securities to the fund at $50.40 per ETF share
• b.Buying ETF shares in the market and redeeming them with the fund for the underlying securities, which are then sold
• c.Redeeming ETF shares with the fund for cash at the $50.40 market price instead of the lower basket value
• d.Delivering the basket of underlying securities to the fund for new ETF shares and selling those shares✓

At a premium, the authorized participant earns the difference by buying the underlying basket at $50.00, delivering it for newly created ETF shares and selling those shares at $50.40; the extra supply pushes the ETF price toward NAV. Buying ETF shares and redeeming them for the basket is the discount trade. Redemptions are settled at NAV, not at the ETF's market price, and the fund does not buy securities from anyone at the ETF's market price.Investment Company Act Rule 6c-11

A closed-end fund pays distributions at a 9% annual rate, but its net investment income and realized gains cover only 6 percentage points of that. Which statement about the other 3 points is accurate?

• a.They are tax-free because they come from the fund's unrealized appreciation
• b.They may be return of capital, which is not currently taxed but lowers the investor's cost basis✓
• c.They are qualified dividends because the fund labeled the payments as dividends
• d.They are taxable capital gains even though the fund realized no gains

A distribution larger than the fund's earnings and profits is treated as return of capital. It is generally not taxed when received, but it reduces the investor's basis and so raises the gain, or lowers the loss, when the shares are sold. A label does not turn it into qualified dividends. Without realized gains there is no capital-gain distribution. Unrealized appreciation is not distributed income, and paying out capital instead lowers NAV.IRC s.301(c); IRS Pub. 550

A client wants to sell shares of an interval fund two weeks after the fund's most recent repurchase offer closed. Which statement is accurate?

• a.The fund must redeem at NAV on any business day, as an open-end fund does
• b.The shares can be sold daily on an exchange at market price, as with a listed closed-end fund
• c.The client generally must wait for the next periodic offer, which the fund makes every 3, 6 or 12 months✓
• d.The client can require repurchase after 30 days' written notice

Interval funds are not listed and have no secondary market. They make periodic repurchase offers at intervals of three, six or twelve months, each for between 5% and 25% of outstanding shares under Rule 23c-3, so the client must wait for the next one. Daily exchange trading describes a listed closed-end fund, and daily redemption at NAV describes an open-end fund. No rule lets a shareholder compel repurchase on notice.Investment Company Act Rule 23c-3

An investor puts $1,000,000 into a hedge fund charging a 2% management fee on beginning assets and a 20% performance fee on profit after the management fee. The portfolio earns 15% before fees for the year. What is the investor's ending value?

• a.$1,100,000
• b.$1,104,000✓
• c.$1,101,600
• d.$1,120,000

Gross ending assets are $1,150,000. The management fee is 2% x $1,000,000 = $20,000, profit after it is $150,000 - $20,000 = $130,000, and the performance fee is 20% x $130,000 = $26,000. The investor keeps $1,150,000 - $20,000 - $26,000 = $1,104,000. $1,100,000 charges the performance fee on the gross $150,000. $1,120,000 leaves out the management fee, and $1,101,600 computes the management fee on ending instead of beginning assets.Advisers Act s.205(a)(1) and Rule 205-3 (performance fees); private fund offering documents

A hedge fund charges a 20% performance fee on gains above a high-water mark equal to the highest year-end NAV per unit after fees. A unit ends year 1 at $116 after fees (it was $100 to start). In year 2 it falls to $108, and in year 3 it rises to $120 before the year-3 fee. What is the performance fee per unit for year 3?

• a.$0.80, charged only on the $4 above the $116 mark✓
• b.$4.00, charged on the entire $20 climb from the original $100 starting value
• c.$2.40, charged on the whole $12 recovery from the year-2 low of $108
• d.$0, because the unit must first recover its year-2 loss before any fee applies

The high-water mark is $116, so only the $4 rise from $116 to $120 is fee-eligible: 20% x $4 = $0.80. $2.40 charges 20% on the whole $12 recovery from $108, which includes gains that merely make up the year-2 loss. $4.00 charges 20% on the entire climb from the original $100. $0 would be right only if the unit finished at or below $116, but it finished above the mark.Advisers Act s.205(a)(1) and Rule 205-3 (performance fees); private fund offering documents

A hedge fund relies on Section 3(c)(7) of the Investment Company Act and may sell only to qualified purchasers. Which prospective investor, a natural person, qualifies?

• a.A person with $350,000 of income in each of the last two years
• b.An individual who owns $5.5 million in investments, not counting a primary residence✓
• c.A married couple with $1.4 million of net worth, not counting their home
• d.A person with a $5 million net worth, $3 million of it a primary residence

A natural person is a qualified purchaser if he or she owns at least $5 million in investments. Net worth is not the test, and a net worth that includes a $3 million home leaves well under $5 million of investments. The $1.4 million couple and the high earner can be accredited investors, which is enough for a Section 3(c)(1) fund, but neither meets the investments test.Investment Company Act s.2(a)(51); s.3(c)(7)

An investor commits $2,000,000 to a private equity fund. The general partner calls 25% of commitments in year 1 and 15% in year 2. How much must the investor still stand ready to fund?

• a.$1,200,000, the 60% of the commitment not yet called✓
• b.$800,000, the amount already called
• c.$1,500,000, after subtracting only the year-1 call
• d.$1,700,000, after subtracting only the year-2 call

Called capital is 25% + 15% = 40% of $2,000,000, or $800,000, so the unfunded commitment is $2,000,000 - $800,000 = $1,200,000. $800,000 is the paid-in capital, not the remainder. $1,500,000 subtracts only the year-1 call, and $1,700,000 subtracts only the year-2 call.NASAA Series 65 Exam Content Outline, Section II (Investment Vehicle Characteristics); private fund limited partnership agreement terms

Why do private equity funds typically report negative net returns in their early years before turning positive?

• a.Management fees and expenses accrue while portfolio companies are still held near cost and have not matured✓
• b.Holdings are priced daily at market, so early market swings in the portfolio companies depress reported returns
• c.Investors must fund the whole commitment at closing, and the idle cash earns nothing until companies are bought
• d.Carried interest is paid to the general partner up front, before capital is invested, which lowers early net returns

This is the J-curve. Fees and expenses are charged from the start, while investments are valued near cost until companies grow or are sold, so reported returns dip before gains arrive. Carried interest is paid after capital and any preferred return are returned, not up front. Capital is called as deals are found rather than all at closing, and private holdings are valued periodically by the manager, not priced daily.NASAA Series 65 Exam Content Outline, Section II (Investment Vehicle Characteristics); private equity fund return reporting

A taxpayer in the 24% federal bracket receives a $1,000 ordinary dividend from a REIT, has held the shares long enough, and can take the full 20% deduction for qualified REIT dividends. About how much federal income tax is owed on the dividend?

• a.$192, taxed after the 20% deduction✓
• b.$150, a qualified dividend taxed at 15%
• c.$48, the 24% rate applied to the deduction
• d.$240, the full dividend taxed at 24%

REIT dividends are not qualified dividends, so they are taxed at ordinary rates, but the Section 199A deduction removes 20% of the amount from taxable income: ($1,000 - $200) x 24% = $192. $240 ignores the deduction. $150 treats the dividend as a qualified dividend taxed at 15%. $48 applies the 24% rate to the deduction itself instead of to the income left after it.IRC s.199A(b)(1)(B); IRS Pub. 550

A REIT reports net income of $50 million, depreciation on real estate of $30 million and a $10 million gain on a property sale. With 20 million shares outstanding, its funds from operations (FFO) per share is:

• a.$2.00, ignoring depreciation entirely
• b.$4.00, leaving the property gain in FFO
• c.$3.50, after the gain is taken out✓
• d.$4.50, adding the gain to FFO

FFO is net income plus real estate depreciation and amortization, less gains on property sales: $50 + $30 - $10 = $70 million, or $70 / 20 = $3.50 per share. $4.00 forgets to remove the gain. $4.50 adds the gain instead of subtracting it. $2.00 ignores depreciation and subtracts the gain from net income only.Nareit FFO definition

A client's mid-cap value fund returned 6% for the year while the S&P 500 returned 11%. Which comparison best judges the manager's skill?

• a.The fund's return against the S&P 500, the market the client could own instead
• b.The fund's return against whichever index had the highest return that year
• c.The fund's return against a mid-cap value index matching its stated size and style✓
• d.The fund's return against the top-quartile peer funds

A fair benchmark reflects the fund's stated size and style, so a mid-cap value index isolates what the manager added. The S&P 500 holds large-cap stocks of every style, so the gap partly reflects the market segment rather than skill. Picking the best-performing index is cherry-picking. Top-quartile peers are a target for a few managers, not the standard for judging the manager.NASAA Series 65 Exam Content Outline, Section II (Investment Vehicle Characteristics); performance measurement against a benchmark

In mid-December an investor puts $30,000 into a mutual fund at $30.00 per share. Two days later the fund pays a $1.50 per share long-term capital gain distribution, which the investor reinvests. What is the tax result?

• a.The $1,500 is taxable this year as a long-term capital gain, even though NAV fell by the same amount✓
• b.The $1,500 is a short-term gain because the investor owned the shares only two days before the distribution
• c.The $1,500 is ordinary income taxed at the investor's bracket
• d.The $1,500 is not taxed until the investor sells shares because it was reinvested in additional shares of the fund

The investor owns 1,000 shares, so the distribution is $1,500. Capital gain distributions are taxable to shareholders in the year paid, reinvested or not, and are long-term regardless of how long the investor held the fund. The investor's position is unchanged because NAV drops by the amount paid out, so the tax is owed on gains earned before the purchase. Reinvestment gives no deferral, and the holding period of the fund shares does not alter the character.IRC s.852(b)(3); IRS Pub. 550

An investor buys one XYZ 50 call for $5.00 and sells one XYZ 60 call for $2.00, both with the same expiration. What are the spread's maximum gain and maximum loss, ignoring commissions?

• a.Maximum gain $1,000; maximum loss $300
• b.Maximum gain $700; maximum loss $500
• c.Maximum gain $700; maximum loss $300✓
• d.Maximum gain $300; maximum loss $700

This is a bull call spread with a net debit of $5.00 - $2.00 = $3.00, or $300 per spread. The maximum loss is that debit, $300. The maximum gain is the $10 strike gap less the debit, $7 x 100 = $700, reached when the stock is at or above $60. $1,000 forgets to subtract the debit. $300 and $700 swap the two figures. $500 counts only the long call's premium as the cost.OCC, Characteristics and Risks of Standardized Options

An investor buys one ABC 70 put for $6.00 and sells one ABC 60 put for $2.00, both with the same expiration. What is the break-even price at expiration?

• a.$64
• b.$66✓
• c.$58
• d.$74

This is a bear put spread. The net debit is $6.00 - $2.00 = $4.00, and the position breaks even when the stock is at the higher strike less the debit: $70 - $4 = $66. $64 subtracts only the long put's premium. $74 adds the debit instead of subtracting it. $58 subtracts the short put's premium from the lower strike, which is not how the spread's break-even works.OCC, Characteristics and Risks of Standardized Options

An investor bought 500 shares at $80, then bought five 75 puts for $2.00 each and sold five 90 calls for $2.00 each. At expiration, ignoring dividends and commissions, what are the maximum loss and maximum gain?

• a.Maximum loss $2,500; maximum gain $5,000✓
• b.Maximum loss $2,500; gain unlimited
• c.Maximum loss $40,000; maximum gain $5,000
• d.Maximum loss $5,000; maximum gain $2,500

The two premiums offset, so this is a zero-cost collar. The put floors the loss at ($80 - $75) x 500 = $2,500, and the short call caps the gain at ($90 - $80) x 500 = $5,000. Unlimited gain forgets that the short call caps it. A $40,000 loss ignores the protective put. Swapping the figures reverses the $5 downside and $10 upside distances.OCC, Characteristics and Risks of Standardized Options

XYZ stock trades at $62. The 60 call is quoted at $4.50 and the 60 put at $1.25. What is the time value of each option?

• a.Call $2.50; put $1.25✓
• b.Call $2.00; put $1.25
• c.Call $4.50; put $1.25
• d.Call $2.50; put $0

Time value is the premium less intrinsic value. The call is in the money by $2, so its time value is $4.50 - $2.00 = $2.50. The put is out of the money, with zero intrinsic value, so its whole $1.25 premium is time value. $4.50 treats the call's entire premium as time value. A put of $0 assumes an out-of-the-money option has no time value. $2.00 reports the call's intrinsic value instead of its time value.OCC, Characteristics and Risks of Standardized Options

An investor buys one ABC 40 call for $3.00 and one ABC 40 put for $2.00, same expiration. What are the break-even prices at expiration?

• a.$38 and $43
• b.$37 and $42
• c.$30 and $50
• d.$35 and $45✓

A long straddle costs $3.00 + $2.00 = $5.00 and must be recovered from either side, so the break-evens are $40 - $5 = $35 and $40 + $5 = $45. $38 and $43 apply each leg's own premium to its own side, which ignores the cost of the other leg. $37 and $42 do the same with the premiums crossed. $30 and $50 double-count the cost.OCC, Characteristics and Risks of Standardized Options

An investor holds one index call with a 4,500 strike and a multiplier of $100. At expiration the index settles at 4,560 and the call is exercised. What happens?

• a.The holder receives the index stocks, valued at $6,000
• b.The holder pays $450,000 and receives the index stocks
• c.The holder receives $60 in cash
• d.The holder receives $6,000 in cash✓

Index options are cash-settled: the holder receives (4,560 - 4,500) x $100 = $6,000, and no securities change hands. Delivery of the component stocks and payment of the strike value describe settlement of an equity option, which is not how an index option works, and an index cannot be delivered. $60 leaves out the $100 multiplier.OCC, Characteristics and Risks of Standardized Options

An investor who owns 200 shares of XYZ wrote two covered XYZ 40 calls. With the stock at $46, the holder exercises both calls well before expiration. What happens to the investor?

• a.Nothing happens until expiration, because equity options can be exercised only then
• b.The investor must deliver 200 shares and receives $8,000✓
• c.The investor may pay the $1,200 difference in cash instead of delivering shares
• d.The investor delivers 200 shares and receives $9,200, the market value

Equity options are American style, so holders can exercise at any time, and each assigned short call obliges the writer to deliver 100 shares at the strike: 200 x $40 = $8,000. Exercise only at expiration describes European-style options. The writer is paid the strike, not the market price. A cash-settlement alternative applies to index options, not to options on a stock.OCC, Characteristics and Risks of Standardized Options

A farmer expects to harvest 50,000 bushels of corn and sells ten 5,000-bushel futures contracts at $4.50. At harvest the cash price is $4.00 and the futures price has fallen to $4.05. The farmer sells the corn and buys back the futures. What is the farmer's effective total revenue, ignoring costs?

• a.$225,000
• b.$202,500
• c.$200,000
• d.$222,500✓

The cash sale brings 50,000 x $4.00 = $200,000, and the short futures gain $4.50 - $4.05 = $0.45 x 50,000 = $22,500, for $222,500. A perfect hedge ($225,000) would require the cash and futures prices to fall by the same amount; here the basis weakened by $0.05. $200,000 is the unhedged result. $202,500 values the corn at the final futures price instead of the cash price.CFTC/NFA futures hedging concepts

An investor buys two E-mini S&P 500 futures at 5,000, where each index point is worth $50. Initial margin is $12,000 per contract and maintenance margin is $11,000 per contract. The contract settles at 4,970, and the broker requires equity restored to the initial level. What additional deposit is needed?

• a.$1,000
• b.$0, because the loss is unrealized
• c.$24,000
• d.$3,000✓

The daily loss is 30 points x $50 x 2 contracts = $3,000, which lowers equity from $24,000 to $21,000, below the $22,000 maintenance level. A margin call follows, and variation margin of $3,000 restores equity to the $24,000 initial level. $1,000 only restores the maintenance level. $24,000 would redeposit the entire initial margin. Futures are marked to market daily, so a loss that is unrealized in the position still has to be paid in cash.CFTC/NFA futures margin rules

A manager holds a $10 million stock portfolio that closely tracks the S&P 500 and wants to hedge it fully with index futures. The index is at 5,000 and each futures index point is worth $50. Which position does that?

• a.Buy 40 contracts
• b.Sell 20 contracts
• c.Sell 40 contracts✓
• d.Sell 2,000 contracts

One contract controls 5,000 x $50 = $250,000 of index value, so $10,000,000 / $250,000 = 40 contracts, and a short position offsets losses on the portfolio if the market falls. Buying 40 contracts doubles the exposure instead of hedging it. 2,000 ignores the $50 multiplier, and 20 uses a $100 multiplier, which belongs to index options.CFTC/NFA futures hedging concepts

A $1,000 convertible bond is convertible into 20 shares, and the stock trades at $52. The bond's market price is $1,150. What is its conversion premium over conversion value?

• a.11.0%
• b.About 9.6%
• c.15.0%
• d.About 10.6%✓

Conversion value is 20 x $52 = $1,040. The premium is $1,150 - $1,040 = $110, and $110 / $1,040 = 10.6% of conversion value. 15.0% measures the premium against par instead of conversion value. 9.6% divides by the bond's price. 11.0% divides the $110 premium by par.NASAA Series 65 Exam Content Outline, Section II (Investment Vehicle Characteristics); convertible securities

A company's 6% convertible bonds ($1,000 par) convert at $40 per share and are callable at 103. The stock trades at $55 when the company announces a call. What should a holder do?

• a.Hold the bonds, because a convertible cannot be called while the stock is above its conversion price
• b.Accept the $1,030 call price, which is above par
• c.Sell the bonds to the company at par under the put feature
• d.Convert into 25 shares worth $1,375 instead of taking $1,030✓

Each bond converts into $1,000 / $40 = 25 shares, worth 25 x $55 = $1,375, which beats the $1,030 call price. A call on a deep in-the-money convertible therefore forces conversion. Accepting $1,030 gives up $345. There is no rule barring a call when the stock is above the conversion price, and a call does not create a put right at par.NASAA Series 65 Exam Content Outline, Section II (Investment Vehicle Characteristics); convertible securities

A company has 10,000,000 shares outstanding and 2,000,000 warrants exercisable at $15, with the stock at $22. An investor owns 1,000,000 shares (10%). If every warrant is exercised for new shares, her ownership becomes about:

• a.8.3%✓
• b.8.0%
• c.9.1%
• d.10.0%

Exercise creates 2,000,000 new shares, so 12,000,000 shares are outstanding and her 1,000,000 shares are 1 / 12 = 8.3%. 10.0% treats warrants like exchange-traded calls, whose exercise does not issue new shares. 9.1% divides by 11,000,000, counting only half the new shares. 8.0% applies the 2,000,000 / 10,000,000 = 20% ratio to the whole 10% stake instead of using the enlarged share count.NASAA Series 65 Exam Content Outline, Section II (Investment Vehicle Characteristics); warrants

An investor with $200,000 of wages receives a $30,000 loss from a limited partnership K-1. She also has $10,000 of passive income from another partnership and enough at-risk basis. How much of the loss can she deduct this year?

• a.$30,000, against her wages
• b.$0, because the loss is deductible only when the partnership is sold
• c.$25,000, under the rental real estate allowance
• d.$10,000, with $20,000 carried forward✓

A limited partner generally does not materially participate, so the loss is passive and offsets only passive income. She can deduct $10,000 now; the other $20,000 is suspended and carried forward. Wages cannot absorb passive losses. The $25,000 allowance is for actively participating rental real estate and not for limited partnership interests. A suspended loss is released in full at disposition, but passive income frees up part of it earlier.IRC s.469; IRS Pub. 925

A limited partner invests $40,000 cash in an equipment-leasing partnership. Her share of the partnership's nonrecourse debt is $60,000, and her allocated first-year loss is $70,000. Assuming plenty of passive income, how much loss can she deduct under the at-risk rules?

• a.$100,000, equal to cash plus her share of the debt
• b.$70,000, because cash plus her share of the debt exceeds the loss
• c.$40,000, with $30,000 suspended✓
• d.$0, because limited partners are not at risk for any amount

The at-risk rules limit deductions to the cash invested and debt for which she is personally liable. Nonrecourse debt generally does not count outside qualified real estate financing, so her at-risk amount is $40,000. The other $30,000 is suspended until she has more at-risk basis. Counting the $60,000 share of nonrecourse debt is the common mistake. She is at risk for her cash, so the amount is not zero. A $100,000 deduction would also exceed her $70,000 allocated loss.IRC s.465; IRS Pub. 925

A customer buys a five-year structured note from a bank that promises full return of principal at maturity plus 60% of an index's gain. Two years later the bank fails and cannot pay its debt. What is the customer's position?

• a.The principal protection is only as good as the issuer, so the customer is an unsecured creditor of the bank✓
• b.The note is backed by a portfolio of the index stocks held in trust, which the customer can claim in the failure
• c.The customer keeps full protection of principal because the note was registered with the SEC and sold by a broker-dealer
• d.The principal is guaranteed by the index sponsor, so it is paid in full regardless of the bank's failure

A structured note is an unsecured debt obligation, so its principal guarantee depends on the issuer's creditworthiness. If the issuer defaults, the holder stands among the unsecured creditors. The index sponsor does not guarantee the note. The note is not backed by a pool of index stocks held for the customer. SEC registration is a disclosure requirement, not a guarantee of payment.FINRA Regulatory Notice 12-03 (complex products)

A customer invests $10,000 in a one-year reverse convertible note paying a 12% coupon, with a 70% knock-in barrier on an underlying stock. The stock closes the year down 40%, below the barrier, and the note is settled by delivering shares. Counting the coupon, what is the customer's approximate result?

• a.A loss of $4,000, because the coupon does not offset the decline in the stock
• b.A gain of $200, because only the 10% below the barrier is lost and the coupon more than covers it
• c.A gain of $1,200, because the coupon was guaranteed and the loss is capped at the barrier
• d.A loss of about $2,800, leaving shares worth $6,000 plus $1,200 of coupons✓

A reverse convertible is a bond plus a short put the investor has written on the stock. The 40% drop breached the barrier, so the customer receives shares worth $10,000 x 60% = $6,000. The coupon is paid regardless, adding $1,200, so the net result is $7,200 against $10,000 invested, a $2,800 loss. A gain would require the principal to be protected, which it is not once the barrier is crossed. Ignoring the coupon overstates the loss at $4,000. Once the barrier is breached the investor bears the whole decline from the starting price, not just the part below the barrier, so a $200 gain is wrong.FINRA Regulatory Notice 12-03 (complex products)

Two products track the same commodity index, one an ETF holding futures and one an ETN. What risk does the ETN holder bear that the ETF holder does not?

• a.Daily margin calls, since an ETN is a margined futures position
• b.Inability to sell until the next net asset value is calculated
• c.Capital gain distributions from the fund's portfolio trading
• d.The issuer's credit risk, since the ETN is an unsecured debt obligation✓

An ETN is an unsecured debt note of a financial institution and holds no underlying portfolio, so the holder depends on the issuer's creditworthiness even if the index performs well. ETN holders are not margined and make no margin deposits. An ETN has no portfolio to trade, so it does not pass through capital gain distributions. Like an ETF, an ETN trades on an exchange all day at market prices, rather than once a day at net asset value.SEC Investor Bulletin: Exchange Traded Notes (ETNs)

An index starts at 100, rises 10% on day one, and falls 10% on day two, ending at 99. An inverse ETF seeks the opposite of the index's return each day. What is the inverse fund's two-day return, approximately?

• a.A gain of 1%
• b.A loss of 2%
• c.No change
• d.A loss of 1%✓

The inverse fund loses 10% on day one and gains 10% on day two: 0.90 x 1.10 = 0.99, a 1% loss, even though the index also lost 1%. Daily resetting compounds each day's result from a new base, so over more than one day the fund does not deliver the opposite of the index's cumulative return. A 1% gain is what an investor would expect from the index's 1% decline. No change is wrong because the day-one loss is taken on a larger base than the day-two gain. A 2% loss is not produced by either day's compounding.FINRA Regulatory Notice 09-31 (leveraged and inverse ETFs)

A retired client receives a variable annuity payout based on a 4% assumed interest rate. This year the separate account earns 7%, net of expenses. What happens to her next year's payment?

• a.It falls, because the earnings exceeded what the insurer assumed
• b.It stays the same, because the number of annuity units is fixed
• c.It is fixed for life at the amount of the first payment
• d.It rises, because the account earned more than the assumed rate✓

Under the variable payout option each payment equals the fixed number of annuity units times the current unit value. The unit value moves up when the account earns more than the assumed interest rate, and down when it earns less, so earning 7% against 4% raises the payment. The number of units is fixed, which is why that option is tempting, but the unit value is what changes. Earning more than the assumed rate never lowers the payment. A payment that never changes describes a fixed annuity.SEC Investor Bulletin: Variable Annuities

A 50-year-old withdraws $20,000 from a nonqualified deferred annuity. She paid $50,000 in premiums and the contract is worth $80,000. How is the withdrawal taxed?

• a.$20,000 is a return of basis and is not taxable
• b.All $20,000 is ordinary income, plus a 10% additional tax of $2,000✓
• c.$7,500 is ordinary income, the pro rata share of earnings, with no penalty
• d.$20,000 is taxed at long-term capital gain rates because the contract is a securities account

Withdrawals from a nonqualified annuity contract entered into after 1982 come out earnings first (LIFO), so her first $30,000 of withdrawals is all taxable ordinary income. She is under age 59 1/2, so the 10% additional tax of $2,000 also applies. A pro rata split is the rule for annuitized payments, not for withdrawals. Basis comes out last, not first. Annuity earnings are never taxed at capital gain rates.IRC s.72(e)(2), s.72(q)

A client's nonqualified variable annuity has a $60,000 basis and is worth $90,000. She wants to move to another insurer's annuity without paying tax now. Which statement is correct?

• a.A Section 1035 exchange works, her $60,000 basis carries over, and the new contract starts its own surrender schedule✓
• b.A Section 1035 exchange resets her basis to $90,000, so the $30,000 gain is never taxed by anyone
• c.She can withdraw the $90,000 and avoid tax on the gain by depositing it in a new annuity within 60 days
• d.A Section 1035 exchange also lets her move the money into a life insurance policy tax-free, since both are insurance contracts

A direct exchange of one annuity for another is a tax-free Section 1035 exchange. The basis and the deferred gain carry over to the new contract, and the new contract usually starts a new surrender charge period. An exchange of an annuity for a life insurance policy is not covered, because the code allows life insurance for annuity but not the other way. The 60-day rollover is a retirement account rule that does not apply to nonqualified annuities, and cashing out is taxable. The basis does not step up, so the gain is deferred, not erased.IRC s.1035(a)

A client annuitizes under a life annuity with a 10-year period certain and dies after receiving payments for four years. What happens next?

• a.The beneficiary receives the remaining six years of payments✓
• b.The beneficiary receives the remaining value of the account as a lump sum, with no further payments
• c.Payments stop at death, and the insurer keeps the remaining value
• d.Payments continue for the remaining six years only if the client was under 59 1/2 at annuitization

A period certain guarantees payments for the stated number of years even if the annuitant dies early, so the beneficiary receives the remaining six years of payments. Payments stop at death under a straight life option, which has no period certain. After annuitization there is no account value left to pay as a lump sum, because the contract has been converted to an income stream. Age 59 1/2 matters for the 10% additional tax on withdrawals, not for the survivor payments.SEC Investor Bulletin: Variable Annuities

A 45-year-old owns a life insurance policy that failed the seven-pay test. The cash value is $150,000, premiums paid are $100,000, and she takes a $30,000 policy loan. What are the tax results?

• a.The $30,000 is taxable income but the 10% additional tax does not apply to loans
• b.The $30,000 is a tax-free loan because it is borrowed, not withdrawn
• c.The $30,000 is taxable as income and a 10% additional tax of $3,000 applies✓
• d.The $30,000 is tax-free because it comes from the $100,000 of premiums first

A policy that fails the seven-pay test is a modified endowment contract. Loans and withdrawals are taxed gain first, up to the $50,000 of gain in the policy, so the whole $30,000 is income, and because she is under 59 1/2 the 10% additional tax applies, which is $3,000. Tax-free loans are the rule for ordinary life policies, not MECs. Basis-first (FIFO) treatment applies to non-MEC withdrawals. The additional tax applies to loans from a MEC as well as withdrawals.IRC s.7702A; IRC s.72(e)(4)(A), (e)(10)(A); IRC s.72(v)

An unrelated investor buys a $500,000 life insurance policy from the insured for $80,000 and pays $20,000 of premiums afterward. When the insured dies, how much of the $500,000 is taxable income to the investor?

• a.$0, because life insurance death proceeds are always income-tax free
• b.$400,000✓
• c.$420,000
• d.$500,000

Death proceeds are normally income-tax free, but a transfer of a policy for valuable consideration limits the exclusion to the amount paid plus later premiums unless an exception applies, such as a transfer to the insured. The investor is not the insured, so the exclusion is $80,000 + $20,000 = $100,000, and the other $400,000 is taxable. Treating the proceeds as always tax free ignores the transfer-for-value rule. $420,000 leaves out the premiums paid after the purchase. $500,000 would tax the whole benefit.IRC s.101(a)(2) (transfer-for-value rule)

A fund holds near-month crude oil futures and rolls them each month. The futures curve is in contango, and the spot price is unchanged over the year. What is the likely effect on the fund?

• a.The fund gains from the roll only if the investor's account is margined
• b.The fund gains, because the later contract's higher price is earned as the expiring contract's spot return
• c.The fund tracks the unchanged spot price exactly, since futures converge to spot
• d.The fund loses value, because each roll sells a cheaper expiring contract and buys a more expensive one✓

In contango, later contracts cost more than the expiring one. Each roll sells the expiring contract and buys the dearer one, so the fund pays the roll cost and loses value even when spot is flat. Futures converge to spot only at expiry and the fund never holds to that point. The higher later price is a cost, not a gain. Margin is a deposit requirement and has no effect on the roll cost.CFTC/NFA; commodity pool disclosure concepts

In January 2024 the SEC approved listing and trading of shares of several spot bitcoin exchange-traded products. A client asks what that approval means. Which response is accurate?

• a.The approval makes bitcoin an exempt security, so the products need no prospectus or risk disclosure to investors
• b.The SEC approved the products for listing but did not endorse bitcoin, which remains highly volatile✓
• c.The shares are FDIC-insured up to $250,000, so the client cannot lose money on a fall in bitcoin's price
• d.The SEC endorsed bitcoin as a safe store of value and said it could replace the dollar for retail payments

The SEC's statement was that it approved the exchange rule changes to list and trade the shares, and that it did not approve or endorse bitcoin. Bitcoin prices remain volatile and the shares can lose value. The SEC did not endorse bitcoin as a currency substitute. FDIC insurance covers bank deposits, not exchange-traded products. The shares themselves are registered securities with disclosure documents, so the approval creates no exemption from disclosure.SEC Statement on spot bitcoin exchange-traded products (January 10, 2024)

A client bought one bitcoin for $20,000 in March 2024. In January 2026 she used it to buy a car worth $35,000. What is the tax result?

• a.A $35,000 long-term capital gain, because the whole value of the car is the gain
• b.A $15,000 short-term capital gain, because the sale was a purchase of goods
• c.A $15,000 long-term capital gain, because digital assets are treated as property✓
• d.No tax, because she never converted the bitcoin to dollars

The IRS treats virtual currency as property. Spending it is a disposition: the gain is the $35,000 value received less the $20,000 basis, $15,000, and because she held it more than one year (March 2024 to January 2026) it is long term. Skipping dollars does not avoid tax on a property exchange. Holding period, not the purpose of the sale, sets long-term versus short-term. $35,000 ignores her $20,000 basis.IRS Notice 2014-21; IRS digital assets guidance

An investor in the 37% ordinary bracket and 20% long-term capital gain bracket realizes a $10,000 gain on regulated futures contracts held for two months. Ignoring other taxes, what is the federal tax on the gain?

• a.$2,680✓
• b.$2,000
• c.$2,850
• d.$3,700

Gains on Section 1256 contracts, such as regulated futures, are treated as 60% long-term and 40% short-term, regardless of holding period. The tax is $6,000 x 20% + $4,000 x 37% = $1,200 + $1,480 = $2,680. $3,700 treats the entire gain as short term because the contracts were held for two months. $2,850 uses a 50/50 split. $2,000 treats the entire gain as long term.IRC s.1256

An adviser's affiliated broker-dealer will act as broker for both an advisory client and the buyer on the other side of a trade. Which step lets the adviser rely on the SEC's agency cross rule?

• a.The client approves each cross trade by phone before it is sent, and the adviser notes the call in the file
• b.The adviser charges the client a lower commission than it would on an ordinary trade of the same size
• c.The client gives advance written consent after full written disclosure that the firm will hold conflicting loyalties on both sides✓
• d.The adviser sends a confirmation after each trade, and no advance consent is needed if the price matches the prevailing market price on the exchange

Rule 206(3)-2 gives a safe harbor from the principal and agency-cross consent requirement only if the client has signed a written consent that prospectively authorizes agency crosses, given after full written disclosure that the firm acts as broker for both parties, collects commissions from both, and has a potentially conflicting division of loyalties. Confirmations and annual statements are also required, but they do not replace advance written consent. A good price or a low commission does not cure the missing consent.17 CFR 275.206(3)-2(a)(1)

An advisory client signed a valid prospective consent to agency cross transactions. In which situation does the SEC safe harbor still NOT cover a particular cross trade?

• a.The client holds the security in a taxable account instead of a retirement account
• b.The cross trade is executed at the last sale price reported on the exchange where the stock is listed, and the client is told about it afterward
• c.The affiliated broker earns a disclosed commission from the client and also from the other party
• d.The adviser, or an affiliate under common control, recommended that same trade to both the seller and the buyer✓

Rule 206(3)-2(a)(5) removes the safe harbor when the adviser, or a controlled, controlling or commonly controlled person, recommended the transaction to both the seller and the purchaser. Executing at the last sale price is consistent with best execution, collecting commissions from both sides is the very conflict that the written consent covers, and account tax status is irrelevant to the rule.17 CFR 275.206(3)-2(a)(5)

Under the agency cross rule, what must an adviser include in the written disclosure statement it sends to each consenting client at least annually?

• a.The total number of agency cross transactions since the last statement and the total commissions or other remuneration received✓
• b.The realized gain or loss on each cross trade and the tax lot method used to figure it
• c.The adviser's estimate of the price improvement the client got compared with an open market execution on the same day, based on its own model
• d.The name of the counterparty on the other side of every cross trade completed during the period, along with the price paid by each

Rule 206(3)-2(a)(3) requires an annual disclosure, sent with or as part of the account statement, that identifies the total number of agency cross transactions during the period and the total commissions or other remuneration received by the adviser and anyone relying on the rule. It does not require counterparty names, tax data, or price-improvement estimates, although the adviser must still seek best execution.17 CFR 275.206(3)-2(a)(3)

A private fund has $150 million of capital contributions and uncalled committed capital. To keep venture capital fund status under SEC Rule 203(l)-1, what is the most it may hold, right after acquiring an asset, in assets that are not qualifying investments or short-term holdings?

• a.$45 million, which is 30 percent of its contributions and uncalled commitments
• b.$22.5 million, which is 15 percent of its contributions and uncalled commitments
• c.$30 million, which is 20 percent of its contributions and uncalled commitments✓
• d.$15 million, which is 10 percent of its contributions and uncalled commitments

Rule 203(l)-1(a)(2) caps non-qualifying, non-short-term assets at 20 percent of aggregate capital contributions and uncalled committed capital, so 0.20 x $150 million = $30 million. The 15 percent figure is the separate leverage limit, which is why it tempts, but it does not apply to this basket.17 CFR 275.203(l)-1(a)(2)

A venture capital fund has $80 million of capital contributions plus uncalled commitments and needs short-term bridge financing. Which borrowing fits within Rule 203(l)-1?

• a.$16 million on a non-renewable term of 90 calendar days
• b.$12 million on a non-renewable term of 90 calendar days✓
• c.$12 million rolled over every 90 days for as long as the fund needs it
• d.$12 million on a non-renewable term of 150 calendar days

Leverage is capped at 15 percent of contributions and uncalled capital, here 0.15 x $80 million = $12 million, and any borrowing must have a non-renewable term of no longer than 120 calendar days. The rolled-over loan is renewable, the $16 million loan is 20 percent, and the 150-day term exceeds the 120-day limit.17 CFR 275.203(l)-1(a)(3)

Which feature is consistent with the SEC's definition of a venture capital fund?

• a.Investors hold interests that carry no right to redeem or require repurchase, except in extraordinary circumstances✓
• b.Investors may require the fund to repurchase their interests at net asset value once a year after a lock-up period ends
• c.The fund has elected to be regulated as a business development company under the Investment Company Act of 1940 and reports to the SEC
• d.Thirty percent of the fund's capital is invested in shares bought on a national exchange

Rule 203(l)-1(a)(4) allows the fund to issue only securities that give no right, except in extraordinary circumstances, to withdraw, redeem or require repurchase, though pro rata distributions are fine. An annual repurchase right, a BDC election, and a 30 percent exchange-traded basket (above the 20 percent limit on non-qualifying assets) each defeat the status.17 CFR 275.203(l)-1(a)(2), (a)(4), (a)(5)