FINRA Series 7 — All Questions

A bond held in a fixed UIT portfolio is called, and the trustee receives the proceeds. What happens to the money?

• a.It is reinvested by the portfolio manager in similar bonds of the same quality
• b.It is held in cash until the trust's stated termination date
• c.It is converted into additional units for each holder in the trust
• d.It is passed to unit holders rather than reinvested in new bonds✓

A UIT holds a fixed portfolio with no manager making new investment decisions, so principal from called or maturing bonds is passed along to holders. A manager cannot reinvest because there is none, and the trust does not hold the cash or issue new units for investors.Investment Company Act Section 4(2)

During the accumulation phase of a variable annuity, an owner invests $2,500 when the accumulation unit value is $12.50 and another $3,000 when it is $15.00. Later the unit value is $16.00. What is the value of the owner's units?

• a.$6,400✓
• b.$7,040
• c.$5,866.67
• d.$5,500

The first payment buys 200 units and the second buys 200 units, a total of 400 units, and 400 x $16.00 = $6,400. $5,500 is only the total invested. $7,040 treats all $5,500 as bought at $12.50 per unit, and $5,866.67 treats all of it as bought at $15.00.Variable annuity accumulation units

A 50-year-old holds a nonqualified variable annuity with a $60,000 cost basis and a $90,000 value. He withdraws $10,000 without annuitizing. What are the tax results?

• a.The full $10,000 is ordinary income, and a 10% additional tax of $1,000 applies✓
• b.The full $10,000 is ordinary income, and no penalty applies because the account is not a retirement plan
• c.$3,333 is ordinary income and $333 is a penalty, since the withdrawal is part basis and part earnings
• d.The $10,000 is tax-free because it is under his cost basis, and no penalty applies

Withdrawals from a nonqualified deferred annuity are treated as earnings first, so the first $30,000 of withdrawals is all taxable ordinary income, and the 10% additional tax applies before age 59 1/2. A pro rata split would apply only to annuity payments, using an exclusion ratio, rather than to withdrawals. Cost basis is recovered last. Retirement plan status is not needed for the 10% tax under Section 72(q).IRC Section 72(e) and 72(q)

An investor paid $60,000 for an immediate annuity with an expected total payout of $80,000 and receives $8,000 each year. What part of each annual payment is taxable until the basis is recovered?

• a.$6,000
• b.$4,000
• c.$8,000
• d.$2,000✓

The exclusion ratio is $60,000 / $80,000 = 75%, so $6,000 of each $8,000 payment is a return of cost and $2,000 is taxable. $6,000 is the excluded amount, not the taxable one. $8,000 treats the full payment as taxable, and $4,000 splits it in half.IRC Section 72(b)

A customer wants to exchange an existing contract without recognizing gain. Which exchange does Section 1035 NOT cover?

• a.A life insurance policy for a deferred annuity
• b.A deferred annuity for a life insurance policy✓
• c.A life insurance policy for another life insurance policy
• d.A deferred annuity for another deferred annuity

Section 1035 allows life insurance to be exchanged for life insurance, endowment, annuity or long-term care contracts, and an annuity for another annuity or long-term care contract. It does not allow an annuity to be exchanged for a life insurance policy, so that exchange triggers tax on the gain. The other three exchanges are permitted.IRC Section 1035(a)

A registered representative holds only a Series 7 and wants to sell variable annuities to clients. What else must she have?

• a.A Series 6 registration in addition to the Series 7 she holds
• b.A Series 24 general securities principal registration
• c.Nothing more, because a variable annuity is a security and the Series 7 covers it
• d.A state insurance license with authority to sell variable contracts✓

A variable annuity is both a security and an insurance product, so the seller needs a securities registration and a state insurance license. The Series 7 already qualifies her to sell variable contracts as securities, so a Series 6 adds nothing, and principal registration is for supervisors. Saying nothing more is needed overlooks the insurance side.FINRA Rule 1220; state insurance licensing

A customer proposes exchanging her deferred variable annuity for a new one. Which is a required consideration before the representative recommends the exchange?

• a.Whether the exchange qualifies under Section 1035, since a tax-free exchange is by itself suitable
• b.Only whether she has done another deferred variable annuity exchange in the past 12 months
• c.Whether she would face a surrender charge, start a new surrender period, or lose existing benefits such as a death benefit✓
• d.Whether she has reached age 59½, because only then may a Section 1035 exchange be recommended

Rule 2330 requires consideration of whether the customer would incur a surrender charge, be subject to a new surrender period, or lose existing contractual benefits, and the firm must also look at any other deferred variable annuity exchange in the preceding 36 months, not 12, and as one factor among several rather than the only one. A tax-free Section 1035 exchange can still be unsuitable. The age of 59½ matters for the tax on early withdrawals, not as a condition of recommending an exchange.FINRA Rule 2330(b)(1)(B)

A policyholder owns a $250,000 variable life policy. The separate account suffers heavy losses for three years. Which statement is accurate?

• a.The death benefit stays at $250,000 or more while in force; the cash value can fall✓
• b.Neither is guaranteed, and the death benefit can fall to the level of the cash value
• c.The cash value is guaranteed, but the death benefit may fall below $250,000 if the account falls
• d.Both the death benefit and the cash value are guaranteed against investment loss by the insurer

Variable life guarantees a minimum death benefit, the face amount, as long as the premiums are paid, while the cash value rises and falls with the separate account and is not guaranteed. The statement that the cash value is guaranteed reverses this. Neither value being guaranteed ignores the minimum death benefit, and guaranteeing both describes no variable product.Variable life insurance (separate account)

A variable annuity has a 7-year surrender schedule (7%, 6%, 5%, 4%, 3%, 2%, 1%) and permits an annual penalty-free withdrawal of 10% of the contract value. In the third contract year the value is $50,000 and the owner withdraws $12,000. What is the surrender charge?

• a.$420
• b.$250
• c.$350✓
• d.$600

The free amount is 10% of $50,000, or $5,000, so $7,000 is subject to the third-year charge of 5%, giving $350. $600 applies 5% to the whole withdrawal. $250 applies 5% to only the free amount. $420 uses the year-two rate of 6% on the excess.Variable annuity contract terms

A REIT has $8,000,000 of REIT taxable income for the year. What is the smallest dividend deduction that satisfies the distribution test and avoids corporate-level tax on the distributed income?

• a.$8,000,000
• b.$7,200,000✓
• c.$6,400,000
• d.$7,600,000

A REIT must pay dividends of at least 90% of its taxable income, so 90% of $8,000,000 is $7,200,000. The 95% test gives $7,600,000 and was the rule before 2001. 80% gives $6,400,000, and $8,000,000 is the amount needed to avoid all tax, which the rule does not require. The REIT is taxed on any retained income.IRC Section 857(a)(1)

A client has $20,000 of suspended passive losses from a limited partnership and receives $5,000 in dividends from a REIT. May the passive loss offset the REIT dividend?

• a.Yes, but only if the REIT's shares are publicly traded on an exchange
• b.Yes, but only up to 50% of the dividend under the passive activity limits
• c.No, because REIT dividends are portfolio income, not passive income, for tax purposes✓
• d.Yes, for the full $5,000, because the REIT's income comes from real estate

Passive losses can only be used against passive income. Dividends from a REIT are portfolio income, so a limited partnership loss cannot shelter them, and a REIT cannot pass its own losses through to the investor either. Real estate holdings, a 50% cap, or listing status do not change the character of the dividend.IRC Section 469(e)(1)

Which fact would prevent a corporation from qualifying as a REIT?

• a.The shares are held by 150 shareholders, none owning more than 5%
• b.Five or fewer individuals own 60% of the shares in the last half of the tax year✓
• c.At least 75% of its assets are real estate, cash and government securities
• d.It distributes 92% of its taxable income to shareholders each year

A REIT must have at least 100 shareholders and cannot be closely held, meaning five or fewer individuals cannot own more than 50% of the value during the last half of the year. 150 holders satisfies the minimum. A 92% payout is above the 90% floor, and the 75% asset test is a requirement that the corporation is meeting.IRC Section 856(a)(5), (a)(6), (h)

A limited partner is allocated a $15,000 loss in a real estate program. He has $4,000 of passive income from another partnership and $90,000 of wages. How is the loss treated this year?

• a.$15,000 offsets his wages and reduces his taxable income this year
• b.$4,000 offsets passive income, and the other $11,000 is permanently lost
• c.$3,000 offsets ordinary income, and the rest is carried forward to later years
• d.$4,000 offsets passive income, and the other $11,000 is suspended and carried forward✓

A limited partner's loss is passive and can only offset passive income, so $4,000 is used this year. The unused $11,000 is suspended and carried forward to future passive income or the sale of the interest. Wages cannot be reduced by it. The $3,000 limit belongs to capital losses, and a passive loss is not forfeited.IRC Section 469

A real estate limited partnership defaults on a $2,000,000 mortgage, and the property sells for $1,500,000. The partnership has no other assets. Beyond the amount they invested, who is exposed to the $500,000 deficiency?

• a.No one, because a partnership cannot owe more than the property is worth
• b.Each limited partner, in proportion to units owned
• c.The limited partners and the general partner equally
• d.The general partner, who has unlimited liability for partnership debts✓

A general partner is personally liable for partnership obligations, so the deficiency reaches the general partner. A limited partner who does not take part in management risks only the investment, unless the offering documents call for additional contributions. A partnership can owe more than its asset value, and shared liability ignores the structure.Uniform Limited Partnership Act (liability of partners)

A limited partner paid $25,000 for units. This year he is allocated a $5,000 tax loss and receives a $3,000 cash distribution. What is his adjusted basis at year end?

• a.$17,000✓
• b.$20,000
• c.$22,000
• d.$23,000

Basis starts at $25,000. It is reduced by the $5,000 allocated loss and by the $3,000 cash distribution, which is a tax-free recovery of capital up to basis, so $25,000 - $5,000 - $3,000 = $17,000. $23,000 adds the distribution to basis. $22,000 omits the loss, and $20,000 omits the distribution.IRC Sections 705(a) and 731(a)

Before recommending a direct participation program, a representative must have reasonable grounds to believe which of the following about the customer?

• a.The customer qualifies as an accredited investor under Regulation D of the Securities Act
• b.The customer will be able to use all of the program's tax deductions in the first year
• c.The customer has a net worth of at least $1,000,000 excluding the primary residence
• d.The customer's net worth is sufficient to sustain the risks, including loss and illiquidity✓

Rule 2310(b)(2) requires reasonable grounds to believe that the participant has a fair market net worth sufficient to bear the risks, including loss of investment and illiquidity, and can realize the program's benefits. The rule sets no dollar figure. The $1,000,000 threshold belongs to the accredited investor definition, which the rule does not make a requirement, and tax deductions are not promised.FINRA Rule 2310(b)(2)

A client's net worth is $2,000,000 excluding her home, and she owns $1,200,000 in investments. A broker offers a hedge fund that relies on Section 3(c)(7). May she buy it?

• a.Yes, as long as the fund has no more than 100 investors
• b.No, because 3(c)(7) funds admit only qualified purchasers, generally those with $5,000,000 invested✓
• c.Yes, because her $2,000,000 net worth excluding her home makes her an accredited investor
• d.No, because hedge fund investors must have a net worth of at least $5,000,000

A 3(c)(7) fund may have an unlimited number of investors, but each must be a qualified purchaser, which for an individual generally means owning at least $5,000,000 in investments. Accredited status is not enough. The 100-investor cap belongs to 3(c)(1) funds, and $5,000,000 is measured in investments rather than net worth.Investment Company Act Section 3(c)(1) and 3(c)(7)

An investor places $1,000,000 in a hedge fund that charges a 2% management fee on beginning assets and a 20% incentive fee on profits after deducting the management fee. The fund earns 12% before any fees. What is the investor's net return?

• a.8.0%✓
• b.10.0%
• c.9.6%
• d.7.6%

Gross profit is $120,000. The management fee is $20,000, which leaves $100,000 of profit, and the 20% incentive fee on it is $20,000. The investor keeps $120,000 - $20,000 - $20,000 = $80,000, or 8.0%. 7.6% takes the incentive fee on the gross profit ($24,000). 9.6% omits the management fee and 10.0% omits the incentive fee.Hedge fund fee arithmetic

A retired customer wants an oil and gas direct participation program with the lowest drilling risk and with current cash distributions as the main goal. Which type is most consistent with those objectives?

• a.A combination program that puts most of its money into new exploratory wells
• b.An exploratory (wildcat) program drilling in unproven areas
• c.A developmental program drilling next to proven fields, to gain tax deductions
• d.An income program that buys interests in producing wells✓

An income program buys producing properties, so it avoids drilling risk and passes production revenue to investors as cash flow. A wildcat program carries the highest risk of dry holes, and its goal is large deductions for drilling costs rather than income. A developmental program drills near proven fields, which lowers dry-hole risk but is still drilling, and its payout is not yet producing. A combination program that leans on exploration brings the same risk as a wildcat program.FINRA Rule 2310 (direct participation programs); oil and gas program types

A Treasury note with a $50,000 face amount is quoted at 98-16. What is the price?

• a.$49,080
• b.$49,500
• c.$49,250✓
• d.$49,125

A Treasury quote of 98-16 means 98 and 16/32, which is 98.50% of par, so $50,000 x 0.985 = $49,250. $49,080 reads the 16 as a decimal (98.16%). $49,500 rounds the quote up to 99. $49,125 reads the fraction as sixty-fourths.Treasury note and bond quotations (32nds)

A 26-week (182-day) Treasury bill with a $10,000 face value is bought at $9,700. Using the 360-day bank discount method, what is the discount yield?

• a.5.93%✓
• b.6.20%
• c.3.00%
• d.6.00%

The discount is $300 on a face value of $10,000, or 3.00%. Annualized on a 360-day year over 182 days, that is 3.00% x 360/182 = 5.93%. 6.20% is the investment (bond-equivalent) yield, which divides by the $9,700 price and uses 365 days. 3.00% is the return for the period, and 6.00% simply doubles it.Treasury bill discount yield (31 CFR Part 356, Appendix B)

A Treasury note with a 4% coupon, $100,000 face and January 15 / July 15 interest dates settles on March 15 of a non-leap year, which is 59 days after the last coupon date. There are 181 days between those dates. What is the accrued interest?

• a.$666.67
• b.$655.56
• c.$646.58
• d.$651.93✓

Treasury accrued interest uses the actual number of days elapsed over the actual days in the coupon period. The semiannual coupon is $2,000, so $2,000 x 59/181 = $651.93. $666.67 uses the 30/360 corporate method (60/180). $646.58 applies the annual coupon over 365 days, and $655.56 uses 59 actual days over a 180-day half-year.31 CFR Part 356, Appendix B (daily interest decimal)

An investor buys a 26-week Treasury bill for $9,700 in November. It matures at $10,000 in May of the following year. When does the investor report the $300 of interest, assuming cash-basis accounting?

• a.In the year of maturity, as interest income, when the bill is paid at its face value✓
• b.In the year of maturity, but as a long-term capital gain on the bill
• c.In neither year, because the discount on a Treasury bill is not taxable
• d.In the year of purchase, since the discount is earned from the day it is bought

The difference between the discounted price and the face value received at maturity is interest income, and a cash-basis investor reports it in the year the bill is paid at maturity, here the following year. Reporting it in the year of purchase applies the accrual treatment of a stripped bond. The gain is interest, not capital gain, and Treasury interest is exempt only from state and local tax, not from federal tax.IRS Publication 550 (Treasury bills)

A resident of a state with an income tax receives $3,000 of interest from Treasury notes and $3,000 from a corporate bond. How is the interest taxed?

• a.Both are subject to federal and state income tax
• b.Both are exempt from state tax, but only the Treasury interest is federally taxed
• c.Both are subject to federal income tax, and only the corporate interest is taxed by the state✓
• d.Only the corporate interest is subject to federal tax, while the Treasury interest is fully exempt

Treasury interest is fully taxable for federal purposes but exempt from state and local income taxes, while corporate bond interest is taxed at every level. Treasury interest does not escape federal tax, which is the feature of municipal bonds. Corporate interest is not exempt from state tax.31 U.S.C. 3124 (Treasury interest exempt from state and local tax)

A customer holds a two-year Treasury floating rate note. A week after the latest 13-week bill auction, the bill's high discount rate rises. What happens to the note?

• a.The spread is raised, while the index part of the rate stays the same until maturity
• b.Nothing changes, because the rate was fixed when the note was issued at auction
• c.The rate resets only at each quarterly payment date, so it stays the same for now
• d.The index part resets weekly, so the rate rises while the spread stays fixed✓

A Treasury FRN has an interest rate equal to an index rate, based on the highest accepted discount rate of the most recent 13-week bill auction, plus a fixed spread. The index resets weekly, and interest is paid quarterly. The rate is not fixed like a regular note, the spread does not move, and resets are not tied to payment dates.TreasuryDirect: floating rate notes

A TIPS has a 2% annual coupon paid semiannually. Inflation has raised its principal from $10,000 to $10,300. What is the next interest payment?

• a.$300
• b.$100
• c.$206
• d.$103✓

Interest is the semiannual rate of 1% applied to the adjusted principal of $10,300, which is $103. $100 uses the original principal and ignores the adjustment. $206 is the annual interest on the adjusted amount, and $300 is the principal increase, which is not paid out until maturity.TreasuryDirect: TIPS interest

A $10,000 TIPS was issued when the reference CPI stood at 250. At maturity the CPI is 240. What principal is paid at maturity?

• a.$10,400
• b.$10,000✓
• c.$9,600
• d.$9,800

At maturity a TIPS pays the greater of the inflation-adjusted principal or the original principal, so the holder never receives less than $10,000 even though adjusted principal would be $9,600 (10,000 x 240/250). $10,400 reverses the index ratio, and $9,800 imagines the loss is shared with the Treasury, which the rules do not provide.TreasuryDirect: TIPS at maturity

During the year, a TIPS holder received $200 of interest, and inflation raised the principal by $300. Neither the increase nor any of the principal was paid out. What is her federal taxable income from the TIPS for the year?

• a.$300
• b.$200
• c.$0, because the increase is not received until maturity
• d.$500✓

Interest paid is taxable, and an increase in the principal of a TIPS is also taxable in the year it occurs, although it is paid only at maturity or sale, so the holder reports $200 + $300 = $500 of income. Reporting only the cash interest ignores the adjustment, and counting only the adjustment ignores the coupon. Waiting until maturity is the treatment for a Series EE bond, not a TIPS.IRS Publication 550 (TIPS); Treas. Reg. 1.1275-7

A customer buys a 10-year Treasury STRIPS at a deep discount and holds it in a taxable account. How is it taxed before maturity?

• a.The accreted discount is taxed as interest each year, though no cash is received until maturity✓
• b.Nothing is taxed until maturity, when the whole gain is taxed as a capital gain
• c.The accretion is exempt from federal income tax because the issuer is the U.S. Treasury
• d.The accretion is taxable only if the customer sells the STRIPS before maturity

A stripped bond is treated as an original issue discount instrument, so the investor includes the accreted discount in income every year as interest (phantom income) although the cash arrives at maturity. Deferral to maturity or sale is not available, the Treasury's guarantee gives no federal exemption, and the accreted amount is interest, not capital gain.IRC Section 1286 (stripped bonds)

A customer owns a GNMA pass-through with an original face of $50,000 and a current factor of 0.8000. The pass-through rate is 6%. What interest does the customer receive for one month, ignoring the principal portion?

• a.$2,400
• b.$3,000
• c.$250
• d.$200✓

The current principal is $50,000 x 0.8000 = $40,000. Monthly interest is $40,000 x 6% / 12 = $200. $250 applies the rate to the original $50,000. $2,400 is a full year of interest on the current balance, and $3,000 is a year of interest on the original balance.Ginnie Mae MBS Guide (pass-through factor)

Mortgage rates fall by 1.5 percentage points. Which risk is most immediate for a holder of a GNMA pass-through with a 7% coupon?

• a.Extension risk, because slower prepayments stretch out the average life of the pool
• b.Prepayment risk, as refinancing returns principal early to be reinvested at lower rates✓
• c.Credit risk, because homeowners default and the holder absorbs the losses
• d.Call risk, because Ginnie Mae may call the certificates at par at any time

When mortgage rates fall, homeowners refinance and prepayments speed up, returning principal early to be reinvested at lower yields. Extension risk is what occurs when rates rise and prepayments slow. A GNMA certificate carries a full faith and credit guarantee, which covers timely payment, and Ginnie Mae has no right to call the certificates.Mortgage pass-through risks

A savings bank wants advances to fund its mortgage lending. Which government-sponsored enterprise borrows in the debt market to make such loans to its member institutions?

• a.The Student Loan Marketing Association
• b.The Federal Home Loan Bank System✓
• c.The Federal Home Loan Mortgage Corporation
• d.The Government National Mortgage Association

The Federal Home Loan Banks raise money by issuing debt, then lend it to members (banks, thrifts, insurers) as advances, secured by mortgages and other collateral. Ginnie Mae guarantees securities backed by government-insured loans and does not lend to institutions. Sallie Mae no longer operates as a GSE, and Freddie Mac mainly buys and securitizes mortgages.Federal Home Loan Bank System

A customer receives a $1,400 monthly payment on a GNMA certificate, of which $1,100 is principal and $300 is interest. What part of the payment is taxable income?

• a.All $1,400
• b.Only the $300 interest✓
• c.Only the $1,100 principal
• d.None of it, because a GNMA is guaranteed by the government

Each payment combines interest, which is taxable, with a return of principal, which is not income because it returns the investor's capital. Taxing the whole payment ignores that, and taxing the principal part reverses it. The full faith and credit guarantee covers payment of the amounts due but does not make the interest tax-free.IRS Publication 550 (mortgage-backed securities)

A customer wants an agency mortgage security whose timely payment of principal and interest carries the full faith and credit of the U.S. government. Which should the representative recommend?

• a.A Ginnie Mae pass-through certificate✓
• b.A Freddie Mac participation certificate
• c.A Fannie Mae mortgage-backed security
• d.A Federal Home Loan Bank consolidated bond

Ginnie Mae, a part of HUD, guarantees pass-throughs backed by FHA, VA and certain other federally insured or guaranteed loans, and the guarantee is backed by the full faith and credit of the United States. Fannie Mae and Freddie Mac are GSEs, and the Federal Home Loan Banks are also GSEs whose obligations lack an explicit government guarantee.Agency securities (GSE vs federal agency)

An investor wants a CMO tranche whose average life stays stable as long as prepayment speeds remain within a stated range. Which tranche is designed for that?

• a.A principal-only strip of the pool
• b.A support (companion) tranche
• c.A PAC tranche✓
• d.A Z (accrual) tranche that accrues interest

A PAC follows a schedule of principal payments that is protected within a band of prepayment speeds, because the support tranches absorb the excess or shortfall. The support tranche takes the variability, so its average life swings the most. A Z tranche accrues interest and receives no cash until earlier tranches retire, and a principal-only strip is highly sensitive to prepayments.CMO tranche structures (PAC and support)

Mortgage rates fall sharply, and prepayments on a pool accelerate. What is the effect on the interest-only (IO) and principal-only (PO) strips of a CMO?

• a.Both fall, because faster prepayments reduce the pool
• b.The PO rises in value, and the IO falls in value✓
• c.The IO rises in value, and the PO falls in value
• d.Both rise, because falling rates raise all bond prices

A PO is bought at a discount and returns its full principal sooner when prepayments speed up, so its yield and value rise. An IO is paid only interest on a balance that is being paid down, so faster prepayments cut its cash flows and its value. The reverse holds when rates rise. Both moving the same way misses this opposite sensitivity.CMO strips (IO and PO)

How does the holder of an accrual (Z) tranche in a sequential CMO receive interest in the early years?

• a.Interest accrues into principal, with cash paid only after the earlier tranches retire✓
• b.Interest is paid in a lump sum only at the CMO's final stated maturity date
• c.Interest is paid monthly in cash from the start, as it is for the first tranche
• d.Interest is paid semiannually in cash, and the principal balance stays level

A Z tranche is like a zero-coupon bond until earlier tranches are paid off: its interest is accrued and added to its principal balance rather than paid, after which it receives cash interest and principal. It is not paid monthly in early years, and it is not deferred until the final maturity of the CMO.CMO tranche structures (Z-tranche)

Under the PSA standard, the 100% benchmark begins at 0.2% CPR in month 1 and rises 0.2% per month to 6% in month 30. What is the CPR in month 12 for a pool assumed to prepay at 150% PSA?

• a.4.8%
• b.9.0%
• c.3.6%✓
• d.2.4%

At 100% PSA, month 12 is 12 x 0.2% = 2.4%. At 150% PSA it is 1.5 x 2.4% = 3.6%. 2.4% is the 100% figure, and 4.8% is the 200% PSA figure. 9.0% applies 150% to the 6% ceiling, which is reached only after month 30.PSA prepayment benchmark

A CDO has a $100 million collateral pool. The structure is a $70 million senior tranche, a $20 million mezzanine tranche and a $10 million equity tranche. The pool suffers $15 million of credit losses. Which allocation results?

• a.Equity loses $10 million and mezzanine loses $5 million, while the senior tranche loses nothing✓
• b.Each tranche loses 15% of its balance, or $10.5 million, $3 million and $1.5 million
• c.Senior loses $15 million before the others lose anything
• d.Mezzanine loses $15 million, and equity and senior lose nothing

Losses fall first on the most junior tranche. The $10 million equity tranche is wiped out, the remaining $5 million reduces the mezzanine tranche to $15 million, and the senior tranche is untouched. A pro rata split ignores subordination, and having the senior tranche absorb losses first reverses the order. The mezzanine tranche cannot take all the loss while equity has a balance.CMO and CDO loss waterfall

An ABS trust holds $105 million of auto loans and has issued $100 million of notes. Ignoring excess spread, the loans suffer $7 million of losses. What is the shortfall to the noteholders' principal?

• a.$5 million
• b.$7 million
• c.$2 million✓
• d.$0

The $5 million of overcollateralization absorbs the first losses. The pool falls to $98 million against $100 million of notes, so the noteholders face a $2 million shortfall. $7 million ignores the cushion, $0 ignores that losses exceed it, and $5 million is the size of the cushion, not the remaining loss.Asset-backed securities (overcollateralization)

A sequential CMO has Class A ($30 million), Class B ($40 million) and Class C ($30 million). The pool pays $5 million of principal this month, and Class A still has $18 million outstanding. Who receives the principal?

• a.Class A receives all $5 million✓
• b.The three classes share it pro rata
• c.Class B receives it, since Class A is partly paid
• d.Class C receives it, because it has the longest maturity

In a sequential structure, all principal goes to the first class until it is retired, then to the next. Classes B and C receive interest on their balances in the meantime. Pro rata sharing describes a pass-through, not a sequential CMO, and the later classes receive principal only after Class A is paid off.Sequential-pay CMO

A firm's brochure for a CMO states that its yield is higher than the yield on a bank certificate of deposit and that it is therefore a better choice. How does this fare under FINRA rules?

• a.It violates Rule 2216, which bars CMO communications from comparing them with bank CDs and other investments✓
• b.It is allowed if the brochure shows the current yields of both products side by side in a table
• c.It is allowed if the brochure is approved by a registered principal before use
• d.It violates Rule 2216 only if the brochure is sent to institutional investors

Rule 2216 bars communications about CMOs from comparing them with other investment vehicles, and it names bank certificates of deposit as an example, so giving both yields does not cure it. Principal approval is required for retail communications generally, but it does not make a prohibited comparison acceptable. The restriction is not limited to institutional recipients.FINRA Rule 2216

A dealer borrows $10,000,000 for 7 days in a repo at 4.50%, using an actual/360 basis. What is the interest cost?

• a.$8,750✓
• b.$8,630
• c.$105,000
• d.$450,000

Repo interest is principal x rate x days/360 = $10,000,000 x 0.045 x 7/360 = $8,750. $8,630 uses a 365-day year, which is not the money market convention for repos. $105,000 treats 7 days as 7/30 of a year, and $450,000 is a full year of interest.Repurchase agreement interest (actual/360)

A customer buys a $1,000,000 negotiable CD issued by a bank and holds no other deposits at that bank in the same ownership category. What amount is covered by FDIC insurance if the bank fails?

• a.$250,000✓
• b.$500,000
• c.$100,000
• d.$1,000,000

FDIC insurance covers $250,000 per depositor, per insured bank, per ownership category, and a large negotiable CD is a deposit like any other. The covered amount does not rise with the CD's size. $500,000 and $100,000 are not the limit, and $100,000 was the limit before 2010.FDIC deposit insurance; negotiable certificates of deposit

A U.S. importer buys machinery from a foreign supplier. The importer's bank accepts a time draft payable in 90 days, which the supplier sells at a discount to a money market investor. What is this instrument?

• a.A negotiable certificate of deposit
• b.A Treasury bill
• c.Commercial paper
• d.A banker's acceptance✓

A time draft guaranteed by a bank, used to finance a trade, is a banker's acceptance. It is sold at a discount and paid at face value at maturity, with the bank's credit behind it. Commercial paper is an unsecured note issued by a corporation, a negotiable CD is a deposit certificate, and a Treasury bill is a government obligation.Banker's acceptance

Which type of money market fund may use a stable $1.00 share price under Rule 2a-7?

• a.An institutional tax-exempt fund
• b.A government money market fund✓
• c.An institutional prime fund
• d.A fund that mainly holds commercial paper sold to institutions

Government and retail money market funds may use stable pricing. Institutional prime and institutional tax-exempt funds must have a floating net asset value, so the share price moves with the portfolio, to reduce the incentive for large investors to run. The type of paper held does not by itself allow a stable price.Investment Company Act Rule 2a-7

Under Rule 2a-7, what is the maximum remaining maturity of any single security a money market fund may hold, for most securities?

• a.60 days
• b.120 days
• c.397 calendar days✓
• d.270 days

Rule 2a-7 generally limits each security to a remaining maturity of 397 calendar days, or about 13 months. The 60-day limit applies to the fund's weighted average maturity, and the 120-day limit to its weighted average life. 270 days is the longest maturity of commercial paper exempt from registration, which is not the fund limit.Investment Company Act Rule 2a-7(d)

A 10-year agency note yielded 4.85% when the 10-year Treasury yielded 4.60%. Later, the agency note yields 4.95% and the Treasury yields 4.55%. How did the spread change?

• a.It narrowed by 15 basis points
• b.It was unchanged, because both yields are near 4.9%
• c.It widened by 15 basis points✓
• d.It widened by 10 basis points

The first spread is 4.85% - 4.60% = 25 basis points, and the later one is 4.95% - 4.55% = 40 basis points, so it widened by 15. The agency yield alone rose 10 basis points. A narrowing would mean the gap shrank, and the gap clearly changed.Yield spread arithmetic

A corporate bond yields 120 basis points over the 10-year Treasury, whose yield is 4.20%. Later the Treasury yield falls to 3.90% and the spread widens to 150 basis points. What is the corporate bond's new yield?

• a.5.70%
• b.5.10%
• c.5.85%
• d.5.40%✓

The new yield is the new Treasury yield plus the new spread: 3.90% + 1.50% = 5.40%. 5.10% keeps the old 120-basis-point spread, 5.70% uses the old Treasury yield of 4.20%, and 5.85% treats the spread as a multiplier of the Treasury yield.Credit spread over Treasuries

A company reports sales of $900,000, cost of goods sold of $520,000, operating expenses of $180,000 and interest expense of $60,000. Its tax rate is 25%. What is its net income?

• a.$90,000
• b.$140,000
• c.$35,000
• d.$105,000✓

EBIT is $900,000 - $520,000 - $180,000 = $200,000. Subtracting interest of $60,000 leaves earnings before taxes of $140,000, and tax at 25% is $35,000, so net income is $105,000. The $140,000 figure is the pre-tax amount, with no tax taken out. The $90,000 figure taxes EBIT at 25% ($150,000) and then subtracts interest. The $35,000 figure is the tax bill itself, not the profit left after it.Financial statements: income statement